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We are upgrading our recommendation on Health Net Inc. (HNT - Analyst Report) to Neutral from Underperform based on its strong financial position and high liquidity. Additionally, the policy of disposing non-profitable businesses, which has enabled the company to concentrate on its core western markets, is a long-term positive.

Health Net, which competes with WellPoint Inc. (WLP - Analyst Report) and UnitedHealth Group Inc. (UNH - Analyst Report), has a strong capital and liquidity position, with total cash and investments of $1.8 billion against total long-term debt obligations of $746 million at the end of March 2012. Additionally, the investment portfolio of the company is strong, with an average rating of “A+” and “A1” as per S&P and Moody’s, respectively.

Moreover, in May 2012, A.M. Best affirmed the issuer credit ratings (ICR) of Health Net as well as the debt rating on the company’s $400 million senior unsecured notes, due 2017, at “bb” with a ‘Stable’ outlook. In the same month, S&P reaffirmed the long-term counterpart credit rating (CCR) of Health Netat “BB”, with a ‘Stable’ outlook. The strong ratings reflect the company’s profitable business mix and strong risk profile, which offset concerns related to the limited geographic expansion and product portfolio.

Health Net has been slowly disposing its non-profitable businesses to improve its bottom line. The divestiture of the Medicare stand-alone Prescription Drug Plan (PDP) business of subsidiary – Health Net Life Insurance Co. – has been beneficial for the company, given the steady decline in its PDP enrollment, along with a constant hike in the PDP Medical Care Ratio (MCR).

On the flip side, Health Net’s total revenue has been declining over the past few quarters, mainly due to lower revenues from the Government Contracts segment arising from the new T-3 TRICARE North contract, which restricted the earnings that can be recognized. The rate of customer attrition in the company’s health plans also remains a cause for concern.

While total health plan enrollment remained almost flat in 2011, it declined 2.6% and 19% year over year in 2010 and 2009, respectively. Membership is expected to remain almost flat in 2012 as well, thus limiting the revenue growth.

Moreover, Health Net had to incur a significant amount of litigation-related expenses in the recent past, which not only increased debt but also weighed heavily on the financial leverage. Last year, the company borrowed $185 million under its revolving credit facility mainly to pay down litigation expenses.

Health Net is expected to report its second quarter 2012 financial results on August 3, 2012 before the bell. The Zacks Consensus Estimate for the company’s second-quarter 2012 earnings stands at 66 cents per share, down 12.8% year over year.

Currently, Health Net carries a Zacks #4 Rank (short-term Sell rating).

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