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We have upgraded our recommendation on Humana Inc. (HUM - Analyst Report) to ‘Neutral’ from ‘Underperform’ on the back enhanced membership, earnings and Medicare coverage driven by strategic acquisitions and alliances.  Improved 2012 earnings guidance also provides optimism. Strong financials and sturdy ratings are the other positives.

Humana’s third-quarter 2012 operating earnings per share outperformed the Zacks Consensus Estimate by nearly 18%. The company expects to deliver earnings in the range of $7.25–$7.35 per share in 2012. It raised the expectation from $6.90–$7.10 per share guided earlier mainly due to favorable development in the prior-year medical claims reserve and enhanced results in the stand-alone prescription drug plan business.

Humana has maintained a strong cash and short-term investment position over the past several years. The company has been utilizing its excess cash to repurchase shares, pay dividends or for other corporate purposes.

Additionally, with the acquisition of Arcadian, SeniorBridge, Concentra and MD Care, Humana has increased its focus on its core business as a health care provider, expanded its Medicare coverage, enhanced the quality of its healthcare services, expanded its provider network in various regions and reduced its exposure to health care overhaul regulations. The deal to buy Metropolitan Health, announced in November 2012, will add 35 state-of-the-art primary care medical centers to Humana’s primary care network.

Even the Certify Data Systems purchase in November 2012 should facilitate the exchange of healthcare data between the company and its patients. Moreover, the exclusive agreement with Veterans of Foreign Wars (VFW), signed in October 2012, should boost Humana’s Medicare Advantage membership and premiums and services revenue.

On the flip side, Humana has been incurring higher-than-expected expenses owing to an increase in operating cost along with depreciation and amortization costs. Increased benefits have also led to deteriorating benefit ratios across most operating segments. Total operating expenses have continuously increased for the company since 2009.

Further, Humana is facing intense pricing pressure from competitors, particularly from BlueCross BlueShield. Moreover, since a significant portion of Humana’s revenues are related to federal government healthcare coverage programs, including the Medicare, TRICARE and Medicaid programs, any adverse change in the reimbursement rates could severely hamper the operating and financial leverage of the company.

Overall, we believe that the company needs to follow prudent expense management and focus on growth through acquisitions and diversifying its earning sources to attract long-term investors. Humana carries a Zacks #3 Rank (short-term Hold). Peer Cigna Corp. (CI - Analyst Report) carries a Zacks #2 Rank (short-term Buy).

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