Goldman Sachs sees significant valuation differences between ASX 200 mining shares Rio Tinto Ltd (ASX: RIO) and Fortescue Ltd (ASX: FMG), which is partly why they rate one stock a buy and the other a sell.
Why ASX 200 mining share Rio Tinto is a buy
Goldman has a buy rating on Rio Tinto with a 12-month share price target of $138.90.
The ASX 200 mining share is currently swapping hands for $130.18, up 0.62% for the day so far.
So Goldman's price target implies a potential 6.7% upside for investors who buy Rio shares today.
The Rio Tinto share price has risen 16.3% over the past 12 months.
The last piece of price-sensitive news out of Rio Tinto was its first-quarter production results on 17 April.
For the three months ended 31 March, Rio Tinto reported quarter-over-quarter production declines of 11% for iron ore, 11% for bauxite, 3% for copper, and 2% for aluminium.
The production drop reflected planned iron ore depletion, predominantly at Yandicoogina; along with a conveyor in the copper operations breaking down for a period.
Goldman analysts Paul Young and Caleb Heiner say Rio Tinto shares are a buy because they're trading below value compared to ASX 200 mining peers BHP Group Ltd (ASX: BHP) and iron ore pure-play Fortescue.
They also cite Rio's "attractive" free cash flow (FCF) and dividend yield.
The analysts are particularly bullish on copper and aluminium and expect Rio to deliver higher copper, iron ore, and aluminium production in 2024 and 2025.
They commented:
Rio is a FCF and production growth story in our view, with forecast Cu Eq production growth of ~4-7% in 2024 & 2025 driven by the ramp-up of the Oyu Tolgoi UG copper mine & a recovery at Escondida and Bingham, higher Pilbara Fe shipments with the ramp-up of new mines, and a rebound in aluminium production + the acquisition of Matalco.
The analysts also mentioned that Rio owns the world's highest-margin low-emission aluminium business, with over 2.2Mt of production powered by hydro.
However, Young and Heiner outline some downside risks for Rio Tinto:
(1) Iron ore and base metal price weakness, (2) WA Heritage Act revision and possible impacts to permitting timelines and operations in the Pilbara, (3) Delays to growth (Oyu Tolgoi, Jadar, Pilbara, Simandou) & decarb, (4) Higher capex and opex due to industry cost inflation.
Why ASX 200 iron ore pure-play Fortescue is a sell
Goldman has a sell rating on Fortescue with a 12-month share price target of $16.90.
The ASX 200 mining share is currently trading at $25.43, up 2.71% for the day on Friday.
So Goldman's price forecast implies a potential 33.5% downside for investors who buy today.
The Fortescue share price has risen 23.1% over the past 12 months.
The last lot of price-sensitive news out of Fortescue was its third-quarter update on Wednesday.
For the three months ended 31 March, Fortescue reported iron ore shipments of 43.3Mt, down 6%, which management attributed to the impact of an ore car derailment along with bad weather.
Young and Heiner said there were four reasons behind their sell rating.
The first is relative valuation, with Fortescue shares trading at an estimated 1.4x net asset value (NAV) and circa 2% FCF compared to 0.9% NAV for fellow major ASX 200 mining shares Rio Tinto and BHP.
Rio and BHP also have better free cash flow of 7% and 6%, respectively.
The broker also spoke of widening low-grade 58% iron ore realisations over the medium to long term, and execution and ramp-up risks at the Iron Bridge project and Gabon iron ore over FY24 and FY25.
Lastly, the broker cites uncertainties relating to Fortescue's energy diversification and the decarbonisation of its Pilbara operations, and how this may impact the balance sheet and future dividends.
The analysts said:
We continue to think FMG is at an inflection point on capital allocation, and to fund the ambitious strategy, we assume the company reduces the dividend payout ratio from the current ~65% in 1H FY24 to ~50% from FY25 onwards (bottom end of the 50-80% guidance range), and increases gross gearing to >30% by FY27 (in-line with the company's target of 30-40%).
However, the analysts can see some upside risks for Fortescue, including:
Ongoing iron ore price strength and possible upside to Chinese and Rest-of-World steel demand, Iron Bridge production ahead of schedule, strong hematite production performance, higher than expected FCF and dividends, possible Fortescue Energy project monetisation and value creation from Pilbara decarb and green hydrogen.
