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We have downgraded our recommendation for Healthways Inc. (HWAY - Analyst Report) to ‘Neutral’, with a price target of $11.00.

The company’s third-quarter 2012 net income declined 46.9% year over year to $5 million, reflecting the loss of the Cigna Corp. (CI) contract. However, adjusted earnings per share of 15 cents managed to beat the Zacks Consensus Estimate of 13 cents, but fell short of the year-ago earnings of 28 cents per share.

Moreover, revenues decreased 5.5% year over year to $166.6 million in the third quarter, missing the Zacks Consensus Estimate of $172 million. Upon exclusion of the Cigna contract, revenues improved 6% year over year, driven by the acknowledgement of performance-based fees.

Additionally, Healthways lowered its expected earnings per share in the range of 24 cents–30 cents for 2012 compared with its prior guidance of 38 cents–50 cents. Revenues were also narrowed to $670 million–$685 million compared with the earlier guidance of $665 million–$705 million.

Growth in the U.S. is expected to slow down, and total number of billable lives may stagnate, which will be partly offset by cross-selling opportunities. On the tepid side, though Healthways considers itself to be a global well-being company, overseas contract wins have been restricted to just a few countries. Moreover, the company’s cash flow remains modest.

However, Healthways is the leader in a strategically critical and rapidly evolving part of the health care services market. The company has invested in technology platforms that provide scalable support to large populations. It has tie-ups with 80% of U.S. health plans and counts about 39 million lives in its customer base. Brisk contract activity may enable the company to gradually get over the loss of the Cigna contract in the third quarter of 2011.

Despite its unique scalable model, Healthways may face many challenges in the short term. The company competes with Express Scripts Holding Company (ESRX - Analyst Report), among others.

We currently have a short-term Zacks #4 Rank (Sell rating) on the stock.

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