Reaffirming Coventry at Neutral

We are maintaining our Neutral recommendation on Coventry Health Care Inc. ( ) based on its improving operating efficiencies, strong 2012 earnings guidance and sturdy capital position.

Coventry generated fourth-quarter 2011 operating earnings per share of 58 cents, which lagged the Zacks Consensus Estimate of 64 cents as well as 96 cents reported in the year-ago quarter.

Improved sales and the retention process implemented since 2009 has transformed Coventry’s Commercial Risk business into a success. The business shrank about 10% in 2009, hurt by the increase in national unemployment. However, it has now become an important source of revenue and contributed almost half of the total operating revenues of Coventry in 2011.

Moreover, the company has a strong balance sheet, which facilitates growth through acquisitions. Coventry acquired Family Health Partners from Children’s Mercy in January 2012, which boosted its Medicaid membership by 210,000 in the combined Kansas and Missouri markets. Moreover, the acquisition is expected to have a modest positive effect on the company’s earnings in 2012.

Further, substantial cash balance and the absence of any debt repayment obligations in the near term allow Coventry to regularly return value to shareholders through share repurchases. The company also initiated a quarterly dividend recently, spurred by the presence of $900 million of deployable cash.

However, the highly competitive environment limits Coventry’s ability to increase premium rates in the fear of losing out prospective policyholders to competitors such as WellPoint Inc. ( WLP - Analyst Report ) , Humana Inc. ( HUM - Analyst Report ) and Health Net Inc. ( HNT - Analyst Report ) . Additionally, the company has to compete with other managed care companies, which have broader geographical coverage, more established reputations, greater market share, larger contracting scale, lower costs and greater financial and other resources.

Moreover, the provisions of the Health Care Reform Act are likely to impact Coventry’s bottom line and the viability of certain Medicare Advantage plans. The company’s annual core earnings have also been largely affected by the implementation of minimum medical loss ratio (MLR) regulation. The MLR mandate led to MLR degradation of 270 basis points for Medicare Advantage and Medicaid products in 2011.

However, we believe that the company’s fundamentals and cost-containment efforts will enhance its long-term growth potential. The Zacks Consensus Estimate for the company’s first-quarter 2012 earnings is currently 61 cents per share, downabout 7.5% year over year. For full-year 2012, the Zacks Consensus Estimate stands at $3.25 per share,up 13.2% over 2011.

Coventry currently carries a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating.