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Executives

Thomas E. Werner - Chief Financial Officer and Senior Vice President of Finance

Sumant Ramachandra - Chief Scientific Officer and Senior Vice President of Research & Development & Medical Affairs

Karen King - Vice President Investor Relations

Michael Michael Ball - Chief Executive Officer, Director and Member of Science, Technology & Quality Committee

Analysts

Gregory Hertz - Citigroup Inc, Research Division

Robert M. Goldman - CL King & Associates, Inc.

Gregory B. Gilbert - BofA Merrill Lynch, Research Division

Frederick A. Wise - Leerink Swann LLC, Research Division

Jessica Fye - JP Morgan Chase & Co, Research Division

Jayson T. Bedford - Raymond James & Associates, Inc., Research Division

Matthew Taylor - Barclays Capital, Research Division

David H. Roman - Goldman Sachs Group Inc., Research Division

Shibani Malhotra - RBC Capital Markets, LLC, Research Division

Marshall Urist - Morgan Stanley, Research Division

David G. Buck - Buckingham Research Group, Inc.

Louise A. Chen - Collins Stewart LLC, Research Division

Hospira (HSP) Q3 2011 Earnings Call October 26, 2011 9:00 AM ET

Operator

Welcome to Hospira's Third Quarter 2011 Conference Call. [Operator Instructions] I will now turn the call over to Karen King, Vice President of Investor Relations. Karen, you may now begin your conference.

Karen King

Thank you. Good morning, everyone, and welcome to our conference call and webcast regarding Hospira's financial results for the third quarter of 2011. Participating in today's call are Mike Ball, Chief Executive Officer of Hospira; Tom Werner, Senior Vice President of Finance and Chief Financial Officer; Sumant Ramachandra, Senior Vice President and Chief Scientific Officer, will also be joining us for Q&A.

We will be making some forward-looking statements today, which are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those indicated. A discussion of these factors is included in the Risk Factors and MD&A section in Hospira's latest annual report on Form 10-K and subsequent Form 10-Qs on file with the SEC. We undertake no obligation to release publicly any revisions to forward-looking statements as a result of subsequent events or developments.

In today's conference call, non-GAAP financial measures will be used to help investors understand Hospira's base business performance. These non-GAAP financial measures are reconciled to the comparable GAAP financial measures in the press release and Form 8-K issued this morning and are also available on the Presentations page in the Investor Relations section of our website.

Also posted on our website is a presentation of complementary material that summarizes the points of today's call. We will not be speaking directly to the material, which is posted on the Presentation page at www.hospirainvestor.com. The material is for your reference to use as an enhanced communication tool. Finally, we will be ending the call at the top of the hour this morning. [Operator Instructions] And with that, I'll now turn the call over to Mike.

Michael Michael Ball

Thank you, Karen, and good morning, everyone. Given the circumstances prompting our third quarter pre-release last week, I'd like to first address the quality-improvement initiatives and resulting slowdown in manufacturing production impacting our financial results, and then we'll walk you through our traditional quarterly review.

For those of you who may not have been on last week's call, let me briefly highlight the chain of events that resulted in heightened remediation activities at Rocky Mount, one of our manufacturing facilities in North Carolina. Rocky is a large facility that accounts for approximately 25% of our overall net sales. It produces generic injectables, large-volume solutions and also is one of the facilities that supports our contracting manufacturing business.

As most of you know, Rocky Mount is under a Warning Letter from the FDA, which we received in April of 2010, related primarily to processing compliance issues. An FDA inspection completed in June 2011 resulted in observations from the FDA known as a 483. The FDA completed another inspection in August 2011, after which we received a second 483 with additional observations.

Receiving 2 483s so close together was a clear signal that we were not making satisfactory progress to fully comply with the FDA's concerns, and that we needed to ramp up our remediation efforts. That is why we escalated the remediation activities at the facility, which resulted in a significant slowdown at the plant, hampering our ability to meet customer demand for product in a timely fashion. It also resulted in inventory write-offs associated with the remediation activities. This development, coupled with device quality-related issues, led to significantly lower third quarter results than we had expected.

I want you to know, first and foremost, that I have heard and appreciate your feedback following our pre-release call. I understand your desire for greater clarity regarding the scope and timelines of remediation, projected costs and overall financial projections.

The situation at Rocky Mount is one we are committed to fix. I can assure you that we are engaging the appropriate internal and external resources needed to address this issue. While I would like nothing more than to lay out clearly defined timelines for remediation, we are not in a position to do that today. When we pre-released last week, we shared the same information regarding our progress that we shared with the FDA in early October, implementing new site leadership, bring in third-party assistance and oversight with Quintiles and IHL, which are regulatory consultants, and reemphasizing that quality is everyone's top priority at the facility.

As part of their oversight, Quintiles and IHL are reviewing several process and compliance aspects of the manufacturing process at the facility. This entails documentation and records review, shop floor oversight, inspection of the test record data and associated issues, such as deviations, lab investigations and manufacturing investigations.

This overall review process is rigorous and is designed to ensure that we are following all processes and procedures required by the FDA, as well as meeting the agency's compliance expectations. Then in addition to production oversight, our third-party partners are focused on assisting in the training and education of the facility's staff. Given Rocky's size and complexity, this is a major undertaking. The additional oversight and enhanced process has created bottlenecks in the flow of activity throughout the facility, and our third-party experts are helping us form solutions to alleviate this bottleneck and return Rocky Mount to a more normal operational levels.

Our expectations for the facility are contingent, both on continued constructive conversations with the FDA and the internal progress and sustainability of our remediation efforts. We know many of you are frustrated and disappointed with this setback. Believe me, so am I. But we will get past this issue. We are following a disciplined process intended to meet every deadline we have committed to the agency. We remain confident that we will successfully navigate this issue and look forward to being able to share with you our progress along the way.

Now I'd like to turn to our sales results for the quarter, after which Tom will discuss the financials. As a reminder, references on this call to net sales results are on a constant-currency basis, which excludes the impact of foreign currency fluctuations. Our press release provides full details on the impact of foreign currency on net sales by segment and product line.

On a constant-currency basis, net sales were up slightly compared to the third quarter of 2010. By product line, Global Specialty Injectable net sales increased 9% for the quarter. Strong net sales performance from our product's launch over the past year more than offset the impact from Rocky Mount.

By segment, Specialty Injectable net sales in the Americas were up 11% for the third quarter, primarily related to contribution from docetaxel in the U.S., as well as many of our other SIP drugs including gemcitabine, propofol and vancomycin.

Drilling down into the growth drivers for the quarter. First, docetaxel. While several more competitors entered the market, we continued to see solid demand for our single-vial solution product. We were able to maintain market share levels at close to 50%, and pricing remain fairly rational, declining to approximately 50% to 55% off the branded product pricing.

We benefited not only from sales of docetaxel to our wholesaler customers, but also from reversals to the chargeback provisions we had recorded in previous quarters as a result of the stable pricing we saw during the third quarter. Over 60% of the docetaxel sales were due to the third quarter wholesaler demand, with the remaining 40% resulting from changes to our original chargeback estimate.

Gemcitabine. We received approval for our gemcitabine solution product during the third quarter and launched it in September. While we have seen positive demand for the product, the freeze-dried portion of the market has become ultra competitive now that all the exclusivity periods have ended, which resulted in well-saturated channels by the time we launched our solution product. The increasing competition has also resulted in further price erosion, which is currently at 80% to 85% off the branded product pricing. Despite the highly competitive environment, we have been able to maintain our share of approximately 15% of the total market, which we believe is due to the full portfolio of powder and solution product we have to offer our customers.

Turning to vancomycin. Vancomycin is one of our older product that has benefited in recent months from our strong focus on supply recovery. You may recall that we built up backorders on vancomycin late in 2009 and have been working hard to reduce the backorders since then. I am pleased to announce that we currently have no backorders, and with ample supply this molecule, we are the industry leader with 70% share of the market.

EMEA. Turning now to the EMEA segment, net sales of specialty injectables were up 2% compared with the third quarter of 2010. Exceptionally strong performance in meropenem and volume share gains on core injectables were offset by expected competitive pricing pressure, primarily on oncology molecules.

Net sales of Specialty Injectables in Asia-Pacific increased 3% over the prior third -- year third quarter, primarily a result of strong performance by Precedex in Japan and continued momentum with both docetaxel and meropenem in the region.

Turning now to Medication Management. Global net sales declined 7% versus the third quarter of 2010. All markets were impacted during the quarter by the soft sales of our Plum device, as we worked to complete validation of our new circuit board components needed to remediate the alarm issue some of the pumps have experienced.

We completed the validation in October. And as a result, we are ramping up our field remediation of devices currently in use by existing customers and have begun shipping Plum orders to customers. Due to a large number of installed Plum pumps, all of which we need to remediate, we expect this alarm activity to be completed in 2012.

Regarding our 510(k) submission for Symbiq, our new infusion device, we have received a second round of questions from the FDA on our filing and are in the process of responding to that series of questions. One that is completed, we expect the FDA will make a final decision on the submission.

We continue to make progress on our complete device remediation efforts. In regards to our infusion devices, we have completed the data gathering and are now in the process of analyzing the data to determine what investigations and remediation efforts are required.

Sales in our Other Pharma product line decreased 21% on a global basis, both our contract manufacturing business and large-volume solutions have been impacted by our heightened quality transformation actions at Rocky Mount and resulting delays in releasing product.

With that, I'll now turn the call over to Tom for an overview of our financial results. Tom?

Thomas E. Werner

Thank you, Mike. Adjusted gross margin as a percentage of net sales in the quarter was 37%, down from 42.8% in the third quarter of 2010, due primarily to the impact of costs and revenue losses associated with quality-related actions, as well as cost related to batch inventory loss.

Research and development expense increased 6% in the third quarter to $69 million, primarily related to higher clinical trial spending in 2011. R&D as a percentage of sales was 7.1% compared to 6.9% for the third quarter of last year.

SG&A expense for the third quarter was $150 million, down 6% from $159 million last year. Higher SG&A in 2010 included costs incurred with the July 2010 Javelin acquisition, as well as Project Fuel. SG&A as a percentage of net sales in the third quarter of this year was 15.3%, compared to 16.7% in the third quarter last year.

Adjusted operating income was $142 million compared to $189 million in the third quarter last year. Operating margin was 14.6% compared to 19.9% last year.

Equity income from affiliates was $9 million this year, compared to $1 million in the third quarter last year, again, a result of the contribution from those docetaxel produced at our Indian joint venture. Adjusted diluted EPS for the third quarter was $0.66 compared to $0.74 last year.

Turning to cash flow. Cash flow from operations for the first 9 months of 2011 was $277 million compared to the $235 million generated for the same period last year. The increase this year primarily reflects the timing of chargeback and rebate payments, which were partially offset by higher inventory levels, as well as the timing of the payment of accounts payable.

Capital spending in the quarter was $73 million compared to $62 million last year. The increase primarily reflects investments we're making with respect to capacity expansion efforts. Our cash balance at September 30 was $527 million, which compares to $604 million at the end of last year.

Turning to guidance, we're now projecting net sales growth of 1% to 2% on a constant-currency basis, with an incremental 1% contribution expected from foreign exchange. Our current guidance reflects the anticipated impact on sales of the recent actions we've taken in relation to our quality-related issues, as well as the softness in our medication management business throughout most of the year. Together, these factors are serving to offset some of the positive contribution we've seen from docetaxel.

The impact of the quality-related issues, coupled with the related inventory write-offs in the second half of the year, will result in lower margin projections. Adjusted gross margin is now expected to range between 38.5% and 39.5%, and adjusted operating margin in the range of 16.5% to 17.5%. We are maintaining the adjusted EPS guidance we provided last week, which was $2.95 to $3.05 per share. This reflects our revised projection for the effective tax rate to now range between 21% and 22%.

The guidance assume that production levels at Rocky Mount remain at current levels through the remainder of this year, and that we continue to have write-off of batches of inventory at higher levels at the facility.

Cash flow from operations is now projected to range between $350 million and $400 million from our previously projected range of $650 million to $700 million. The decrease is due to the impact of our lower earnings projections and the fact that we now expect inventories to end the year at higher than previously expected levels.

Full year 2011 depreciation and amortization, we continue to project a range of $230 million to $250 million. We've lowered slightly our full year capital expenditure projections, which are now expected to be between $325 million and $350 million, really due to the timing of spend on our India expansion effort, as well as some delays in project spend given the developments at Rocky Mount.

Before I turn the call back over to Mike, I do want to address estimates for our costs associated with the device remediation efforts, as well as facility remediation that we outlined during our Investor Day in September.

We mentioned last week on our pre-release call that we were revisiting the $200 million to $250 million expected remediation costs. While the anticipated expense for the device reviews has not changed with a more recent actions regarding Rocky Mount, we now believe the total costs will range between $300 million to $375 million, fairly evenly split between device and pharma. Again, we expect that these costs will be incurred and spent over a 2- to 3-year period, with the bulk of the expense expected to occur in the remainder of 2011 and throughout 2012. In addition, when we discussed these cost at Investor Day, we indicated that roughly 70% to 75% of the costs were onetime in nature. With these additional costs, we now expect the onetime costs to represent approximately 65% of the total.

Of the total remediation costs, we expect roughly $100 million to $150 million to hit this year, with roughly 65% of the costs onetime in nature. With that, I'll turn the call back to Mike.

Michael Michael Ball

Thanks, Tom. In summary, the third quarter proved to be a challenging one for Hospira, both in terms of financial results and operational performance. We are remediating the situation at our Rocky Mount, North Carolina facility and are committed to addressing the FDA's observations and requirements.

In addition, we are quickly ramping up the number of remediated Plum pumps we can deliver to new customers, as well as field remediation efforts for existing customers. And we are continuing with the comprehensive device review we have undertaken.

All of these efforts underscore our commitment to providing our customers with the highest-quality products. The changes that we are effecting will make Hospira a stronger, more competitive company that we expect will set the bar on quality, in line with the FDA's heightened requirements for safety and quality.

I want to close by reiterating that I believe Hospira remains an extremely well-positioned company, focused on improving the safety, cost and productivity of patient care and delivering strong long-term value for our shareholders. The fundamental strategies of our business have not changed. While there are challenges, I have faced and fixed challenges before, and my team and I are working 24/7 to get past this challenge. I'm confident we have what it takes to do this, and I am committed to getting Hospira back on track towards sustainable growth.

With that, we are now ready for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Louise Chen with Collins Stewart.

Louise A. Chen - Collins Stewart LLC, Research Division

My question relates to the additional spend that you talked about. As a portion of the pharma spend, can you talk about if any of that mediating spend is going to be for other plans in addition to Rocky Mount or is it really just focused on Rocky Mount?

Michael Michael Ball

The bulk of it's focused on Rocky Mount. 15% to 20% will be some things we need to do at some other facilities, but the lion's share of it is all related to Rocky Mount.

Operator

Our next question comes from the line of Rick Wise with Leerink Swann.

Frederick A. Wise - Leerink Swann LLC, Research Division

Let me try to address a sort of broader issue. We've seen in the past some companies need to raise the bar on quality systems and reporting like this, Mike. How confident are you that your -- you've got the scope right at this point in terms of number of facilities? And I'm not trying to ask a negative question, but is it possible that we're going to see more 483s at other facilities and that you need to do a bigger company-wide upgrade of systems and reporting broader than we see and understand today?

Michael Michael Ball

So Rick, maybe we -- if that suggests kind of talk about 483s to round everybody and then work through some of the specifics around the question. The FDA inspects our facilities as I think you know on a regular basis and reporting an observation on the Form 483. It's certainly undesirable, but it's actually not that unusual outcome from an FDA audit. And the observations can be minor and quickly resolved, or they can be more complex and require more significant and costly remediation efforts. So receiving a 483 in and of itself doesn't necessarily constitute what I'd call a troubled facility or a plant that is on the road to more severe consequences or penalties. So I think it's important to understand that around 483. So when we get a 483, again, from either minor or more non-trivial, let me put it this way, we submitted a response and remediation plan to the FDA and then implement it. In most cases, we don't hear back from the FDA, but at some point in the future, they'll come back and inspect the facility again.

And so common industry practice, which is what we do, we don't typically discuss or distribute 483, because we actually consider them to be a normal part of the business. In a situation where facility is under a Warning Letter though, we do deem subsequent 483 is significant, and that's why we've been talking about the 483 as it relates to Rocky Mount and to Clayton. We have received 483s at other plants.

Most of them have been minor, although I will tell you regarding Austin, and this talks a little bit about the scope, this particular 483 was not trivial. To give you some background, we got a 483 on Austin in April and do, as per the normal course of business, we submitted our response to the agency a couple of weeks later. So about 6 months ago. So we committed to and are continuing to implement a corrective action plan at Austin, while we're waiting to see if the agency has any comments on our response. In addition, I would tell you that the 483 at Austin is not impacting customer service levels unlike the Rocky situation.

Although, again, talking about scope and remediation, we need to ensure that the responses we gave to the FDA's observations, that we fully remediate those observations. We believe at this time that the FDA is still examining the situation, and we think that the FDA is likely, not only just withholding approval to products coming out of Rocky, but are most likely doing the same at Austin. And as a result, what you've seen is levofloxacin, for example, which we submitted earlier this year for product approval or, at least, expect a product approval this year from both Austin and Rocky, that product has been impacted. So as we look at all of our plants, we are looking at them on a holistic basis.

We do have and implemented last year a quality transformation plan that addressed all plants and not just the Rocky Mount and Clayton situations. But given the new observations at Rocky Mount, we are now looking at our Other Pharma sites to ensure there are no common issues. So that's what we are doing precisely at this moment.

So I guess the answer to your question is, on scope, is we have broaden the scope to look at all of our plants. The one plant that stands out from a 483 standpoint, and it's 483 was nontrivial I'll tell you, is the Austin one, and of course, the 483s we got at Rocky Mount.

Frederick A. Wise - Leerink Swann LLC, Research Division

Just quickly follow up on the backorder situation. I appreciate you have to work through the regulatory issues, but is there -- are there any alternatives or is there any other approach that you could take that could help resolve those or work through those or address that issue more quickly than just "fixing Rocky Mount"?

Michael Michael Ball

So some of the obvious solutions that people have mentioned is manufacturing products in other plants. And where we are able to do so, we go that route. But candidly, the process of getting a product approved in another facility is not a timely one. And so, we basically have to attack the backorders at the root place, which is Rocky Mount.

I and my folks have been in contact with the consultants, and we're moving down what I'd call a dual path here. We're ensuring that we're getting the compliance and process fixes in place, but we're also looking at opportunities to expand our bandwidth, so that we can get more production out of the plant. And that, of course, will go to solving the backorder situation. So right now, and in fact, I was in discussions yesterday with the consultants on how we increase this bandwidth, and there are certain actions being taken now that I believe will start to improve that bandwidth.

The issue we have is that we have not seen that as yet, and we need to continue with the assumption that the customer service levels and production levels, let's call it production levels, will continue at the same level that we have seen them, which is approximately 60% to 70% of normal production coming out of Rocky will continue through the end of this year.

Operator

Our next question comes from the line of David Roman with Goldman Sachs.

David H. Roman - Goldman Sachs Group Inc., Research Division

I was hoping we can rewind to the analyst meeting a little bit. You have set out at the time a very aggressive long-term growth program that involved investments across a number of the different portfolios. Since that time, we're talking about another -- over $100 million in remediation expense and what appears to be increasing challenges on the quality control side. Could you maybe help us understand how you're going to manage sort of the increased growth initiatives that you laid out, particularly in the context of the increased focus on spending and also the number of problems that have arisen even in a period of time during which you weren't -- you do not have such an aggressive growth program in place?

Thomas E. Werner

David, it's Tom. As we pull together the 2012 plan, given the recent developments, I wouldn't say that it's likely we're going to cancel anything, but we do need to reevaluate and re-prioritize our ability just financially, as well as bandwidth, to get to all of these initiatives. So we still think that the expansion in Europe is an exciting opportunity for us. And as we pull together the 2012 plan and communicate that to after the first of the year, look for some further color on it. But we do realize what the change in the situation here, we just want to go back and do a reality check on things. Mike, anything that you would add?

Michael Michael Ball

Yes, I think, Tom, I think that's right. David, I think what we're trying to say at the Analyst Day was there are tremendous opportunities out there that are available to us, and it's simply up to us to go and pursue them. We set out a opportunity in terms of moving products into the international area, going after products that have already lost their patent protection and pursuing them, going after opportunities in the developing world. So all these opportunities still exist. As Tom rightly notes, we just have to decide at what pace we pursue them.

But from my standpoint, the long-term fundamentals of this company are still intact. We have definitely hit -- I won't do an injustice by calling it a bump in the road. This is a large bump, no question about it, but this is an internal issue that we can get fixed. And so our pacing maybe different than what we envisioned at the investor call, but those opportunities are not going to go away.

David H. Roman - Goldman Sachs Group Inc., Research Division

Okay. And maybe just a follow-up on that. If you look at the $0.66 of earnings that were reported during the quarter, is it fair to assume that the July -- through July and August were relatively normal months, as they will be in any third quarter in the real [indiscernible] earnings relative to what people had expected came in the back half of September. So the right quarterly run rate is closer to $0.40 to $0.50 not $0.66, which is sort of what's reflected in your guidance?

Thomas E. Werner

No, I don't think that's the right way to look at it. Well, the dropoff certainly happened in September. We were tracking just fine through August. So there was a dropoff, but we did expect that September, as usual, would be a big month for us. The way I sort of try to look at the run rate, if you will, if you take the $0.66 in the third quarter, the tax rate came down, and that's sort of artificial. That won't reoccur. We had to adjust incentive accruals and all, given the financial performance. So that actually benefited performance in the quarter. We had some chargeback adjustments as well. Negatively impacting results in the quarter of that $0.66 base was a temporary slowdown in sales in the quarter related to not having Plum on the market, as well as some of the backorder situations, as well as the plant shutdown that we see both in the third quarter and the fourth quarter. So the way I kind of looked at it is, if you just take what Q4 guidance squeezes to or where Q3 came in at, the run rate is something more in the $0.70, $0.75 range, assuming that the production at the Rocky Mount doesn't get any better, and that we continue to have some inventory write-offs. But that should eventually resolve itself, but for the near term, it's probably not a bad way to look at the run rate.

Operator

The next question comes from the line of Matt Taylor with Barclays Capital.

Matthew Taylor - Barclays Capital, Research Division

I wanted to ask -- I appreciate that it's very difficult to get your arms around the exact timing at this stage. But looking at, I guess, some precedent transactions, it seems like typically with the remediation of this size, it's a multiyear process, and the result has been a number of comparable issues that have resulted in some kind of a stock shift or partial plant shutdown. And I was just hoping that you could speak to the potential of something like that happening. And also, you were able to resolve Clayton, so what's different between Clayton and Austin or Rocky? That would be great.

Michael Michael Ball

I think a few things. So let me just go with what's the difference between Clayton and Rocky. Rocky is 10x the size of Clayton. So out of the size then comes the complexity of the situation. For us, what we've essentially done is taken our successful moves at Clayton with these 2 consultants that we hired there, which was IHL and Quintiles and brought them into the Rocky Mount facility. At Clayton, we actually did do a shutdown, as you recall, and it lasted for some 3 months. There was just a different set of circumstances at Clayton than exist here.

And in discussions with those consultants, and these are the very same people, it's not just the same company, it's the same people within our Clayton facility, what they tell me is that this is a very fixable situation that each of the problems are not overly complex. It just turns out that this is a very large facility. And so that's where the complexity of the situation is.

So we feel like there is a path forward here from folks who have basically been there, done that with us before. And I believe, I have a great deal of confidence in the plan we put forth in the groups that we have brought in that we have a, I would say, clear understanding of what's in front of us. And what we need to do is nail down what is the timing, because the timing is a dictated by, not just looking at each individual process, but again, by the very size of the plant. So I feel very good about the situation in terms of remediation and a way forward. What we do not have a visibility to is the timing.

Matthew Taylor - Barclays Capital, Research Division

And you think you'll avoid a shutdown, I guess, is the other part of that?

Michael Michael Ball

The remediation plan that we gave to the FDA did not envision a shutdown. They certainly did not disagree with our plan. They definitely wanted and challenged us to live up to the commitments of the plan, and that plan does not involve a shutdown. So our view, sitting here today, is if we proceed in our hitting our commitments to the agency and to ourselves, then this will avoid a shutdown.

If we are unable to fix things or the agency feels that we are not fixing them appropriate enough, obviously, they could take some action. And obviously, I'd say that in the context of it's always difficult to predict what the agency will do. But in this situation, the agency has strongly indicated that they are willing to work with us.

Operator

The next question comes from the line of Robert Goldman with CL King.

Robert M. Goldman - CL King & Associates, Inc.

Relative to Austin, Texas, what percent of sales result from that plant? And also you had mentioned with the Austin that no new products were being approved there by FDA. I think you mentioned that with Rocky Mount as well. Is that an assumption on your part, Mike? Or is that something the FDA has told you, and when did they tell you that?

Michael Michael Ball

So from our standpoint on Rocky Mount, it is extremely common when one has a Warning Letter that essentially new product approvals are not forthcoming. As it pertains to Rocky, we didn't really have a number of products or significant number of approvals coming through there. So the impact was, let me call it, negligible. As it pertains to Austin, as we have been investigating the situation around our levofloxacin, we came to believe that there is a action in terms of not approving products out of Austin by the agency. And as we got later into September, we saw some other products impacted by that.

So it started out with levofloxacin, and then it looks like it impacted again some minor products in the September timeframe. But that gave us a certain confirmation that it was beyond levofloxacin, that potentially it involves Austin. But again, it's tough to know as we go through this response to our 483 with them. Is it a situation where they're holding things up until they are convinced that we've remediated it? Or is it a situation where they are looking at further questions of us or looking to do a further inspection? Those kinds of things, we simply don't know at this time. So we're looking at a bit of a black box here. But again, in the spirit of transparency, that seems to have impacted that plant. I should say that as I look at another product, imipenem, this product is actually made over in India. The approval of that product is far slower than we would have expected. I would have expected getting the product out in the summer timeframe. And again, whether or not it's delaying approval is tied up somehow with the agency looking at Rocky Mount, we cannot simply say.

Robert M. Goldman - CL King & Associates, Inc.

And the percent of sales coming out of Austin?

Thomas E. Werner

Bob, it's Tom. I'm going to venture ballpark about 10%, and I'll get back to you with a more precise number. But Austin is IV solutions and just the value to skew is so much lower there. It's a pretty sizable facility from a square footage standpoint. But from a sales standpoint, it's considerably smaller and simpler than is Rocky Mount, but we'll get you a better number. For now, it's just roughly 10%.

Operator

Our next question comes from the line of David Buck with Buckingham Research.

David G. Buck - Buckingham Research Group, Inc.

I guess, more of a broader question, reviewing some of the 483s or the 2 483s from Rocky Mount. Really, for Mike, can you give maybe a better sense that we could go of how long do you think the process will be to get back to where you thought you were trending? And just can you give maybe an update on whether there's any better estimate of what the ongoing costs will be in sort of 2012 and 2013 to get the quality systems to where they should be? And then finally, maybe if you could just give an update on inspection status broadly for the key plants.

Michael Michael Ball

Okay. So Tom, maybe you'll handle the financial question. I'll take the progress of remediation and when we get back to normal. What we're saying at this time is that through the end of the year, the situation that we have today will remain reasonably constant. And beyond that, we do not have great visibility.

And in the intervening weeks since our call last week, we have been working like crazy to see that we give people better transparency into this. And as I said in my prepared text, we just did not feel like we're in a better position to talk about when we may be coming out of this thing. So my preference at this point is to discuss it further on our fourth quarter call, which is end of January, beginning of February.

We obviously will have a lot more information by that time, but the situations are simply unfolding right now. And as I mentioned with respect to our production, we believe that the production did bottom out at 60%. So I'm willing to say that it is jumping around between 60% and 70%. We are not anticipating that will get worse. So hopefully, it trends to either that level or starts to get better, but we do not have a clear line of sight at this point of when it starts to get better.

Thomas E. Werner

Then David, it's Tom. What was the financial aspect you were asking?

David G. Buck - Buckingham Research Group, Inc.

Yes. I guess, just in terms of the production level's expectation. You have bottomed out. You mentioned, Mike, that 60%. So it got worse and there's some costs associated with getting to where you need to be on systems, I guess, beyond and above what you've been talking about the Investor Day. So I'm wondering if there's any incremental costs that you've sort of come up with that you might need to from, say, the consultant fees or...

Thomas E. Werner

No. I think that Investor Day from a capital standpoint, we did signal that we were going to need to spend some money on modernization of our factories, largest, of course, being Rocky Mount. And then in terms of the other costs, we've mentioned that in the remediation cost numbers that we gave earlier on the call today. The rest of those would be covered in the $300 million to $375 million.

David G. Buck - Buckingham Research Group, Inc.

Okay, got you. And just in terms of the inspection status, what should we be expecting next in terms of news flow? Is there anything we should be aware of in terms of inspections that may lead to 483s or Warning Letters?

Michael Michael Ball

So from a inspection status, the -- what our belief is on Rocky Mount is the FDA will be back in there some time in 2012, hopefully, with far better results for ourselves. In terms of other plants, we have the FDA going through our plants all the time. And I believe most key plants got visited this year. And so again, this is just an ongoing process. I guess, the -- again, it's difficult to say, I keep coming back to the Austin facility. It's difficult to say what the next step is there. It could be that they're satisfied with our responses. It could be that they revisit the plant.

Hopefully, we've remediated enough that it will satisfy the agency. In terms of notifying the Street, obviously, if we get into a situation that -- with the agency that is significant, like I would say, a consent decree, we would obviously alert the investment community. But again, as I said before on the fourth quarter call at the end of January and the beginning of February, I think we'll be the best position to discuss where we stand.

David G. Buck - Buckingham Research Group, Inc.

And one final. Has there been any talk at the Board level of perhaps changes at the Board level since the pre-announcement?

Michael Michael Ball

From a Board standpoint, we are giving them a update. Again, from a Board governance standpoint, they already have what's called a ST&Q Committee. So last year, the Science and Technology Committee of the Board took on the additional responsibility of reviewing quality. Now the ST&Q committee actually encompasses all of the board members. So the board members are getting a review of quality. And at the December board meeting, we will be having a in-depth discussion on quality.

David G. Buck - Buckingham Research Group, Inc.

Okay. At this point, there's no change in -- I guess Chris Begley's Executive Chairman status at this point? There's no contemplation of that? I know it's a little bit of an awkward question for yourself, Mike, but...

Michael Michael Ball

There is no changes being disclosed.

Operator

[Operator Instructions] Our next question comes from the line of Gregory Hertz with Citi.

Gregory Hertz - Citigroup Inc, Research Division

A question here, a few financial little ones. If my calculations are correct, you're targeting roughly $7 million increase in recurring costs, which is basically around about 175 basis point headwind on operating margins on a $4 billion run rate. How does that impact your long-term yield and profitability?

And then separately on gross margins, backing out around 200 basis points benefit from a chargeback reversal, I'm getting to around 35% adjusted gross margins in the quarter. On a go-forward basis, is that a more reasonable starting point? And then finally, just a kind overland in gross margin question, one of the things I was surprised a little bit about this quarter was that much more of the shortfall in the Americas was allocated towards other forms versus SIP. I'm wondering because of the margin mix difference between those, is it possible that going forward, you might see a change in production capacity shifted towards SIP where potentially higher profitability products coming out of that facility further dampen gross margins?

Thomas E. Werner

All right, there's about 7 questions in there. So let me try to get to most of them. When you say shortfall higher and Other Pharma SIP I guess it depends whose numbers you're looking at. We actually thought that, to our own numbers, that the shortfall was more pronounced in SIP that it was in Other Pharma. But Other Pharma consist of IV solutions and contract manufacturing, and we did see some slippage in order shipment related to contract manufacturing given the quality issues. So I wouldn't characterize it as more of a miss related to Other Pharma.

In terms of the chargebacks, no, you're not looking at that right. If you were looking at oxaliplatin, I'd probably agree with you. But in the case of docetaxel, remember that we have to subject that to a profit split with the JV. So unlike oxaliplatin, $10 million chargebacks doesn't just drop right through the pretax. It has to get split and then passed back to the joint venture. So that you've got too much of an impact there. But there was an impact, but the way that the split works is that the split doesn't move our overall margins all that much.

So overall, I think you're characterizing that as too big of an impact in the quarter. And then in terms of going forward with the ongoing costs, as I said to David Roman's comments or questions earlier, to look at the run rate of the business with the various pluses and minuses given current capacity, it's probably in the $0.70 to $0.75 range. However, as we look out next year and then look towards the longer-term guidance, given the situation that we're in right now, we're going to need to reevaluate those numbers. And as we pull together our 2012 plan, we will certainly do that.

Operator

Our next question comes from the line of Jayson Bedford with Raymond James.

Jayson T. Bedford - Raymond James & Associates, Inc., Research Division

Just one quick one here. Is it fair to assume that you can ramp production at the Rocky Mount facility without the FDA actually lifting the Warning Letter, meaning is that decision directed by yourselves and the consultants versus the FDA?

Michael Michael Ball

Yes, absolutely. So the control of the plant in terms of how much we manufacture, that is under our control. We need to obviously ensure that the processes and compliance situation is in order, but we can take it up. It's just simply not possible to take it up as we have put in these oversights on ourselves, but I don't think that the agency would have an issue with us taking the products up to a much higher levels. So we are working with all due haste and without the constraints of some sort of imposed reduction in manufacturing. And so we're moving forward to get this up to speed as fast as we can.

Operator

Our next question comes from the line of Greg Gilbert with Bank of America Merrill Lynch.

Gregory B. Gilbert - BofA Merrill Lynch, Research Division

Can you tell us where Precedex is made and is there any potential for disruption there other than the potential generic risk in 2012? And then Mike, on the Clayton versus Rocky comparisons, I'm assuming that on the FDA side, the people involved in Rocky are not the people that were involve at Clayton. So should -- and correct me if I'm wrong there, but should we assume the FDA bar is still the same now and that the key difference really is the size of this plant versus that one? I just want to make sure that it's appropriate to compare the 2.

Michael Michael Ball

Let me take the second one first, and then I'll have Tom comment. So the Clayton is in North Carolina. The Clayton facility in North Carolina, as is Rocky Mount, they are both handled out of the same district office in Atlanta. So you do have commonalities in terms of inspectors going through these. Now they may rotate inspectors through, but basically the same inspectors are covering those plants.

So for example, the individual who looked at Clayton and gave it a thumbs up are the same ones who came into Rocky Mount and gave us the 483s. So we feel like we have a good understanding again from the Clayton example of what needs to get done. And as I said, it's not fancy, we're just basically lifting that playbook. And what I like about it is in talking to the consultants, as I said, they've seen this before. So I have a great deal of confidence in them, that they can drive this thing to the appropriate levels. And that since we do know the FDA inspectors on this one that we know what they're driving to, and we believe that we should be able to meet those commitments.

Gregory B. Gilbert - BofA Merrill Lynch, Research Division

But the bar hasn't changed from then until now in your view?

Michael Michael Ball

No. From my standpoint, the bar has not changed. The progress simply at Rocky Mount, I think just because the facility was 10x bigger was just a much bigger undertaking.

Thomas E. Werner

And then, Greg, at Precedex. Precedex is manufactured at Rocky Mount. The line has not been affected by the production slowdown, and we do have redundant production capabilities in one of the other facilities.

Operator

Our next question comes from the line of Shibani Malhotra with RBC Capital.

Shibani Malhotra - RBC Capital Markets, LLC, Research Division

Just a quick one on product mix at both the Rocky Mount and the Austin facilities. I know you don't identify a specific product, but just wondering how should we -- we should be thinking about the gross margin changes based on what you can and cannot manufacture going forward, at least, for the next couple of years? So that's the first question. And then second on Austin, I know you've said that it's not minor, but when we actually read the 483 letter, it seems very similar to Rocky Mount and that a lot of the issues are related to systemic problems with the lack of responsibility in terms of quality control and manufacturing, et cetera? How easy are those issues to fix in your opinion given they're pretty broad and similar?

Thomas E. Werner

At this time, I'll take the sales mix question and Michael will follow up on Austin. Today, about 80% of what comes out of Rocky Mount is Specialty Injectables. The remainder is largely Other Pharma, which is a combination of contract manufacturing, as well as IV solutions. So IV solutions as we've said, historical margins aren't all that great, especially injectables in Precedex, which is not affected would give you a richer mix coming out of Rocky. So our conclusion to drive is probably that the margin mix coming out of Rocky is probably slightly but not a lot higher than our overall company margins.

Shibani Malhotra - RBC Capital Markets, LLC, Research Division

And this is after the Warning Letter. So it's going to stay like that? Or is this being impacted, I guess?

Thomas E. Werner

Yes, that is largely before the full impact of Warning Letter. So the margins would come down a little. That's a good point.

Michael Michael Ball

And then with respect to Austin versus Rocky, again similar issues around the process and compliance. We have addressed this back to the FDA some 6 months ago. We are continuing with the remediation plan in that particular plant. My hope is that it would be satisfactory if the FDA came to the doors. My hope is it will be satisfactory. But given this 483 in August in Rocky, we are taking nothing for granted. So we, as I mentioned before, are going back into all of our plants to re-audit them and ensure that the progress that they are making is consistent with what we believe the agency needs to see. So that would cover it in terms of Austin from my standpoint.

Operator

The last question comes from the line of Chris Schott with David Morgan.

Jessica Fye - JP Morgan Chase & Co, Research Division

It's actually Jessica on for Chris. I know you guys have -- I understand you're not providing timing around a resolution. But is it possible to just maybe walk through the specific steps, I guess, the process that you need to go through to return to normalized production levels? And then just really quickly, jumping back to the product approvals. Are there any key product approvals coming out that we should maybe think about potentially being impacted by the issues at Rocky and Austin?

Michael Michael Ball

So Sumant will handle the product approval.

Sumant Ramachandra

So currently out of Rocky Mount and Austin, there are no significant product approvals yet pending, other than the one that actually Mike mentioned which was levofloxacin, which was made in those 2 facilities. But in terms of major product approvals, no, there are some minor small ones that Mike has mentioned at a high level that do exist as part of our routine process of changes that occur to our products, but nothing of significance in those 2 plants.

Karen King

Chris -- do you have an additional question?

Michael Michael Ball

Jessica, actually.

Karen King

Jessica?

Jessica Fye - JP Morgan Chase & Co, Research Division

I just trying to kind of steps or the process that we go through from here on the path forwards' remediation, just any absence of timing, just kind of like the steps that we should be thinking about from here?

Michael Michael Ball

Okay. So in terms of the path to remediation, we have the consultants in there as I mentioned. I think in my prepared remarks, we gave a pretty detailed outline of the steps that they are actually looking at. This is not just simply an auditing, an oversight function, but we've actually got them in there doing the training aspects associated with our operators, et cetera. So basically, we are transforming from, as I recall, from the shop floor to top of the house. So we're not just engaging in oversight but its actual training, et cetera. So there's a number of steps. But again, if you review the prepared text, I have them in there as to what they're looking at, but I don't think of many of them are actually sequential. I think many of them are just going on at the same time. So if references to how do we know timelines are progressing, we are going to be building from a qualitative and quantitative standpoint and try to put a dashboard to look at that.

Karen King

Thank you. Ashley, we're going to take one more question please from Marshall Urist. So if you could queue that up? And then Mike will conclude with his closing remarks.

Operator

Our last question comes from the line of Marshall Urist with Morgan Stanley.

Marshall Urist - Morgan Stanley, Research Division

Just a question on -- if you could just walk through your assumptions in terms of the revenue run rate in the fourth quarter, just so we can start to think about 2012? I mean, I know you talked about production in the 60% to 70% range. But if you could talk maybe a little bit about gemcitabine, taxotere, with more competition coming, sort of what you have seen to date in the quarter there would be helpful? And then I presume that we'll see some positive movement on Plum. And I guess just related to that, just if you could give us the -- what's behind your level of confidence that as you again later in maybe more on the -- more on compliance side, what gives you confidence that we're not going to see any incremental impact on that 60% to 70%?

Thomas E. Werner

Okay. On the sales progression, Marshall, its Tom. Sales will be up a little bit. We're expecting Q4 from Q3 Plum back on the market, and some of the contract manufacturing orders that were scheduled for Q3, we think we can get out in Q4. And Q4 was going to be a heavier quarter. Anyways, docetaxel and gemcitabine, there won't be a chargeback adjustment on the top line. So that's roughly $15 million to $20 million that won't be there. And we've assumed further price erosion on gem and a little bit of share erosion on gemcitabine, constant share on docetaxel. So overall, I think revenues will be slightly up. We've got some headwinds from those 2 drugs and then some positives from some other areas, including Asia-Pacific. They've got a pretty good pump order coming in, in the fourth quarter. So that's sort of the sales trend. I didn't catch the second part of your question.

Marshall Urist - Morgan Stanley, Research Division

Just for you guys, about what gives you confidence that you can hold the line at 60% to 70%, if you continue to -- as you continue to do these remediation efforts? What gives you confidence that we're going to see any more incremental impact? Just what we -- just in light of what we saw between, obviously, Analyst Day and last week?

Thomas E. Werner

Yes, that's a good question. We have assumed things don't get better, but we have seen some signs that there has been some improvements. So we really don't think and expect that things will get worse, and early indications are they're gradually getting better. Now should there be some type of unforeseen events, I suppose things could get worse, but we've sort of assumed the 60% output, and that's a pretty drastic reduction. And both Mike and I beefed us up pretty good. So we feel pretty comfortable that that's sort of the valley on the number.

Louise A. Chen - Collins Stewart LLC, Research Division

Are there any more short of major layers of remediation and oversight that are planned to be instituted during the fourth quarter, so that we could see -- so that there could be some impact on lot release? Or are you kind of bare at that point and that's what's driving the fact that it's going to stay at 60%?

Thomas E. Werner

We are making progress as we speak, and we do expect that there will be some slight improvement in batch release, but we've assumed not much improvement at all. Again, however, just like production capacity, we are seeing a slight uptick. So we're encouraged.

Michael Michael Ball

Okay. So why don't I finish up here? First thing I want to do is I want to clarify an answer to a question. Apparently, I was not that clear. So I wanted to be absolutely clear at this point. And that was the question as it pertained to Chris. Now Chris is our Executive Chairman and at such a time where we need to change the, we'll publicly disclose that as required by the law. So I'll be absolutely clear on that, because apparently my statement before was not very good.

In terms of just a final thought, I want to thank you again for your time today on this call. I want to assure you that we are intently focused on our goals, and we will remain the provider and partner our customers look to as a partner to provide solutions to their most pressing needs and the company, our shareholders' trust. So we are looking and working hard to get that trust to a level that I want it at. We're looking to forward to updating you on the remediation efforts and to discuss our 2012 guidance on our year-end earnings call. So thank you very much.

Karen King

Ashley, we can go ahead and end the call. Thank you.

Operator

This concludes Hospira's Third Quarter Conference Call. You may now disconnect.

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