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We reiterated our Neutral recommendation on Molina Healthcare Inc. (MOH - Analyst Report) based on the company’s fundamental growth potential that is likely to have an adverse effect from the ongoing market volatility and other business risks.

Molina reported operating earnings of $0.38 per share in the second quarter of 2011, which were ahead of the Zacks Consensus Estimate of $0.36 per share. Results were also substantially higher than $0.27 per share reported in the year-ago quarter.

Net income soared 64.2% to $17.4 million from $10.6 million in the prior-year quarter. Higher-than-expected premium and Medicaid revenues were partially offset by lower investment revenue and increased medical and operating costs.

Molina has increased its membership historically through the development of new health plans and existing health plans. The widening of the membership base is the primary reason for the increase in revenue as premium revenue accounts for a majority of the revenue generated by the company.

Aggregate membership increased by 32,000 during the first half of 2011, and currently Molina serves nearly 1.65 million members. Additionally, the company’s enrollment in the Medicare special needs plan for dual-eligible members is the tenth-highest in the US.

Moreover, Molina has been expanding its geographic reach via acquisitions. While the acquisition of the Health Information Management business of Unisys Corporation (UIS - Analyst Report) added value to the company’s Medicaid health plan business, the recent acquisition of Abri Health Plan covers 23 counties in Wisconsin and approximately 28,000 Medicaid members.

Besides, despite the cash outlays for inorganic growth, Molina holds a healthy balance sheet with a steadily improving cash flow. Furthermore, the stock split authorized this year will enhance liquidity and maximize shareholders' wealth.

Looking ahead, given the higher-than-expected earnings growth of Molina in the first half of 2011, management has increased its EPS projection for fiscal 2011 to $1.55 from $1.47 earlier, post stock-split. Additionally, Molina expects improved performance from its Idaho fiscal agent contract in the second half of 2011.

However, on the downside, Molina’s rising medical costs are leading to margin compression. The increase in expenses resulted from higher utilization rather than higher unit costs and was most evident in connection with physician and outpatient costs.

igher operating expenses pose a risk to the company’s operating leverage. Additionally, the investment income of Molina has been declining since 2007 primarily due to lower interest rates.

After considering all the pros and cons, the Zacks Consensus Estimate for third-quarter 2011 currently stands at 40 cents per share, up 6.3% year over year. For full year 2011, the Zacks Consensus Estimate is $1.56 per share, up 18% from 2010.

Molina carries a Zacks #3 Rank, which translates into a short term Hold rating, indicating no clear directional pressure on the shares over the near term.

On Wednesday, the shares of the company closed at $18.60, up 4.4%, on the New York Stock Exchange.

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