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We are downgrading our recommendation on Gentiva Health Services Inc. (GTIV - Analyst Report) to ‘Neutral’ based on increased operating and interest expense burden, and the expected negative impact of reimbursement rate cuts. However, strong revenues and enhanced market share via inorganic growth offset these negatives.

Gentiva reported second-quarter 2012 operating net earnings of 35 cents per share, ahead of the Zacks Consensus Estimate of 28 cents but lower than the year-ago quarter level of 47 cents per share. Operating net income of $10.7 million also compares unfavorably with $14.0 million in the year-ago quarter.

Gentiva, which competes with Amedisys Inc. (AMED - Analyst Report) and HealthSouth Corporation (HLS - Snapshot Report), is the largest provider of home health and hospice services in the U.S. based on revenues. Moreover, the company continues to boost its market share and expand its geographic coverage through various strategic acquisitions.

The purchase of Family Home Care Corporation in September 2012 should expand Gentiva’s foothold in the eastern Washington and northern Idaho markets as Family Home Care is one of the market leaders in home health and hospice services in these two states. Further, the acquisition of North Mississippi Hospice in the same month is projected to significantly expand the company’s presence in the Northern Mississippi market as the acquired hospice provider has branches in Tupelo, Oxford and Southaven in Mississippi.

On the flipside, the rising expenses of Gentiva over the past few quarters have been offsetting the increase in revenue, leading to reduced bottom-line growth. Hence, Gentiva requires effective cost control to reap the rewards of rising revenue. Rising expenses have also weakened its operating cash flow over the past few years, although the company still has a considerable cash balance.

Additionally, the credit agreement in March 2012 increased the interest rate on term loans, thereby substantially increasing the company’s future interest expenses. The interest rate hike has also resulted in a substantial decline in the earnings outlook for 2012.

Further, the changes proposed by the Centers for Medicare & Medicaid Services (CMS) in July 2012, for Medicare Home Health Prospective Payment System payments, are expected to trim down Medicare reimbursements by 0.1% in 2013, thereby reducing Gentiva’s earnings, which are significantly reliant on Medicare earnings. The previous Medicare reimbursement cut, proposed in October 2011, is also expected to negatively impact Gentiva’s 2012 net income by $35 million.

Overall, we expect modest growth potential for Gentiva in the long term. The company currently carries a Zacks #3 Rank, implying a short-term Hold rating.

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