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Following Health Management Associates’ third quarter financial results, we have downgraded our long-term recommendation on the leading operator of general acute care hospitals to Underperform from Neutral, with a target price of $7.50.

The company’s third quarter 2012 earnings per share of 18 cents missed the Zacks Consensus Estimate as well as the year-ago earnings by a penny. Revenues (prior to provisioning for doubtful clients) increased almost 19% year over year to $1,664.2 million, easily surpassing the Zacks Consensus Estimate of $1,655 million.

However, net income at Health Management decreased 5.5% year over year to $41.3 million. The decline can be primarily attributed to a challenging operating environment on same hospital basis.

While Health Management continues to improve margins, bad debt expense remains a concern. Bad debt expense came in at 13.5% of revenues in the third-quarter of 2012, higher than 12.8% in the year-ago quarter. The increasing bad debt may affect the bottom line negatively.

Despite the improvement in pricing environment, sustained volume pressure on same hospital basis is an overhang. The declining volume trend implies that Health Management’s primary markets may be somewhat saturated and a lackluster demand may worsen matters for the company. We also remain concerned by inpatient volume growth prospects.

On the positive side, the company is an active acquirer of underperforming hospitals with a turnaround potential in high-growth markets. During the third quarter conference call, Health Management indicated that it has a rich pipeline of high-quality acquisition targets. However, we have doubts regarding the company’s ability to rapidly implement operational improvements at acquired facilities. Also worth mentioning in this context is that the debt burden for the company remains sizeable.

Apprehending our concerns, the 2012 and 2013 Zacks Consensus Estimates have been on a downtrend over the last 90 days not only for Health Management but also for its peers, Community Health Systems (CYH - Snapshot Report) and LifepointHospitals (LPNT - Snapshot Report). This reflects that the hospital franchise is currently plagued by several issues such as hospital admission, Medicare reimbursement issues and regulatory overhangs.

Considering the aforementioned factors, we refrain from suggesting the stock which carries a short-term Zacks #5 Rank (Strong Sell).

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