Pioneer Natural Resources (PXD -0.09%) was a high-flyer in 2013. This year, however, the shares lack upward dynamics, and with a forward P/E of 36, the company is richly valued by the market. In its latest quarterly report, the company stated that it expected production growth in the range of 14%-19% in 2014. Will this growth rate be sufficient to justify the company's valuation?
Capital expenditures will increase further
The company plans to spend $3.3 billion on capital programs in 2014. To fund these expenditures, Pioneer Natural Resources plans to use the $2.3 billion of projected operational cash flow, $0.4 billion of cash on hand, and proceeds from divestitures. It's worth noting that the company's cash flow projections are base on the WTI price of $90 per barrel, which hasn't been seen since April of 2013.
During its earnings call, the company stated that it planned to increase capital expenditures by about 10% in the coming years. So far, the expenses have paid off and the company's assets in the Permian Basin and in the Eagle Ford have performed well.
The Permian Basin continues to be one of the most attractive plays in U.S. The top Permian producer, Occidental Petroleum (OXY -1.18%), expects a 10% compound annual growth rate in the Permian between in the period of 2014 – 2016. Occidental plans to dedicate a sizable chunk of its $10.2 billion capital spending budget to assets in the area. However, growth from other company's assets has stalled, and Occidental expects a 2.2%-3.5% rise in total production.
... and this means the dividend increase is unlikely
Pioneer Natural Resources pays a negligible dividend. When a company's shares appreciate at a healthy rate, investors are happy. When shares stall, however, investors want to see cash returns.
Another top Permian producer, Apache (APA -0.75%) recently increased its dividend by 25%, bringing its annual yield to 1.20%. There's still plenty of room for returning cash to shareholders as the payout ratio is just 11%. However, this figure looks big in comparison with Pioneer Natural Resources' payout ratio of 2%.
Given the plans to gradually increase capital expenditures, Pioneer Natural Resources will continue to spend its operating cash flow on this item. The company stated that it expected the same debt levels at the end of 2014 compared to the end of 2013, which means that it will not issue extra debt.
Is the valuation sustainable?
I believe that Pioneer Natural Resources must hit the top line of its production guidance to justify its share price. While the company spends all its money on growth, it must deliver this growth. Otherwise, investors will be disappointed, and the stock will be punished as a result.
It would be increasingly difficult to maintain existing growth rates as the company gets bigger. Yes, the Permian basin continues to deliver good results for producers. For example, Apache showed a 13% growth in production in the Permian in its recent quarterly report.
The big question is whether Pioneer Natural Resources' growth prospects are enough to keep its shares rising. The stock has corrected 20% since its highs seen in October, but the company remains very generously valued. In my opinion, the potential downside is bigger than the upside, as growth prospects are not big enough to justify the price, and virtually no cash is returned to shareholders.