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We maintain a Neutral recommendation on Coventry Health Care Inc. based on its operating efficiencies, top-line growth, upbeat 2012 earnings guidance, stable ratings and cost-containment efforts. Increased expenses and membership decline in the Commercial Group Risk segment are the downsides.

Coventry reported first-quarter 2012 operating earnings per share of 62 cents, which lagged the Zacks Consensus Estimate by a penny and was also lower than the prior-year earnings of 66 cents. Operating income amounted to $88.3 million in the reported quarter.

Coventry’s capital position and investments in technology and medical management supports its long-term goals. The company is also improving its operating efficiencies, largely through economies of scale.

Moreover, Coventry possesses a strong balance sheet with about $900 million in deployable cash at the end of the first quarter of 2012, which facilitated initiation of a quarterly dividend in March 2012. With no debt repayment scheduled in the next couple of years, the company has ample scope for strategic acquisitions as well as share repurchases and dividend payouts.

Coventry’s operating efficiency, geographic diversification, widespread product portfolio and a strong financial position help retain the confidence of rating agencies. Consequently, in May 2012, A.M. Best affirmed the issuer credit rating of the company at ‘bbb-.‘ The rating agency also reiterated the debt ratings of the company along with a stable outlook on all these ratings, indicating low possibility of any rating change in the near term.

However, the operating cash flow of Coventry fluctuates substantially from quarter to quarter, which may affect normal operations of the company. Annual cash flows from operations also vary substantially. Going ahead, such instability could weigh heavily on the capital and financial leverage, thereby risking the company’s investment and growth targets.

Moreover, high competition limits Coventry’s ability to increase premium rates under the threat of losing out prospective members to competitors such as WellPoint Inc. (WLP - Analyst Report), Humana Inc. (HUM - Analyst Report) and Health Net Inc. (HNT - Analyst Report). The company has to compete with other managed care companies that have broader geographical coverage, more established reputations, greater market share, larger contracting scale, lower costs and greater financial and other resources. Such competition from bigger players will negatively impact Coventry’s membership.

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

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