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On Sep 4, 2013, we downgraded our recommendation on Humana Inc. (HUM - Analyst Report) to Neutral from Outperform despite decent second quarter results due to several operational issues being faced by the company. This health care plan provider currently carries a Zacks Rank #3 (Hold).

Why the Downgrade?

Humana’ second-quarter earnings came in at $2.63 per share, ahead of the Zacks Consensus Estimate of $2.46 by 6.9%. Earnings also grew 21.8% year over year. The strong performance in the company’s Retail, Employer Group, Healthcare Services and Other Business segments led to the increase in income. Revenues during the quarter also climbed 6.4% year over year but marginally lagged the Zacks Consensus Estimate.

However, the ever rising expenses and the waning operating cash flow raise concern.  Higher operating costs have always been a matter of concern for Humana. In the first half of 2013 operating expenses surged 2.3%.

Moreover, there is a rise in membership from people with pre-existing medical conditions and government plans have put restriction on charging higher premiums from these people. As a result benefit expenses are also rising and are taking a toll on margins.

Humana is also facing probe on certain aspects related to Medicare and Medicaid operations in the Florida region that might dampen investors’ sentiment. Capital expenditures of Humana are also increasing and for 2013 it is expected to rise by 3.7%–9.8% over that of 2012.

All these coupled with U.S. economic weakness account for the waning operating cash flow of Humana. The first half of 2013 also suffered significant decline in operating cash flow.

Additionally, the health care reform is weighing on the sale of Medicare Advantage plans on which Humana is largely reliant. Moreover, the establishment of the minimum medical loss ratios is increasing the costs of healthcare companies.

Further, implementation of programs from 2014, such as the ban on annual and lifetime coverage caps, annual fees on health insurance companies and excise tax on high premium insurance policies, will likely increase expenses. All these are likely to pressurize profits going forward.  

However, growth in Medicare membership and stable ratings of the company are some attributes worth mentioning. Its competitive pricing and strategic alliances with companies like Astellas Pharma Inc. (ALPMY), Boehringer Ingelheim Pharmaceuticals, and Greenway Medical Technologies Inc. in the first half of 2013 are expected to help it improve memberships further.

Alongside, it is seeking growth through the inorganic path. With this motive, it entered into an agreement to acquire American Eldercare Inc., one of the leading nursing home diversion services providers in Florida.

Other Stocks to Consider

Among other health care providers, Aetna Inc. (AET - Analyst Report) and Centene Corp (CNC - Snapshot Report) carry a favorable Zacks Rank #2 (Buy).

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