Stocks to Watch in Construction Machinery: Caterpillar Inc. and Terex Corporation

By Markets Fool.com

The U.S. construction industry has finally taken off: In April, housing starts jumped to near seven-year high while total construction spending shot up to its highest level in six-and-a-half years.

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US Housing Starts Chart

US Housing Starts data by YCharts.

Surprisingly, stocks of companies that manufacture construction equipment aren't reflecting any of this optimism. In fact, leading construction-machinery stocks Caterpillar (NYSE: CAT), Terex (NYSE: TEX), and Manitowochave left investors poorer by at least 20% over the past year. Deere, the outlier, has remained flattish over the period.

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CAT data by YCharts.

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Construction machinery companies continue to face several headwinds, including sluggish international markets, currency fluctuations, and lower commodities prices that have hurt demand for equipment used in civil engineering projects in industries such as mining, energy, and utilities.

But that's not to say these companies have nothing to offer investors. Since construction is a cyclical industry, things will eventually turn; and companies that are using the downturn to position themselves for the next growth cycle could ultimately generate great returns for investors. Here are the two top stocks worth watching.

1. Terex
Terex is the only pure-play construction equipment company among those mentioned above, which makes it an obvious choice for someone looking for exposure in the industry. While the U.S. construction market is back on track, key international markets including Latin America, Europe, and China remain challenging. Yet, despite the fact that Terex generates nearly 60% of its sales from outside North America, it ended 2014 with 3% higher revenue,at $7.3 billion.

But Terex spooked investors after it projected to earn only $2-$2.30 per share in 2015 (versus earnings per share of $2.35 last year) on sales between $6.2 and $6.6 billion. However, the muted guidance comes at the back of uncontrollable factors including currency fluctuations and not low demand. Since a stronger dollar translates into lower international revenue, currency headwinds could wipe out nearly $650 million-$750 million from Terex's sales and $0.15 and $0.20from EPS this year.

In fact, demand for Terex's equipment remains strong: After a sequential climb of 17% in the fourth quarter, its backlog order value jumped another 7% sequentially to $2.1 billion in the first quarter. What's noteworthy is that Terex entered the second quarter with a 34% higher year-over-year backlog for aerial work platforms -- its largestdivision, accounting for one-third of its total sales. So if not for currency headwinds, Terex's top line could easily shoot up.

Meanwhile, management plans to take $50 million out of costs this year and improve its operating profit by $202 million over the next few years through restructuring efforts. Terex is targeting $200 million to $250 million in free cash flowthis year, which isn't bad given the cyclicality of its business. With cash flows, shareholder returns should also improve -- the company increased its quarterly dividend by 20% last year after initiating its first dividend in 2013. Terex's return on equity at 15% is impressive.

While analysts estimate Terex's earnings will grow 7% annually over the next five years, it could be higher as the business cycle turns around. Given the growth prospects it offers, Terex looks like a bargain, valued at just under 10 times its forward earnings currently.

2. Caterpillar
Caterpillar only generated 37% of its total revenue from its construction industries business last year, but it remains the world's largest construction equipment manufacturer. Cat's strong global footprint can largely be attributed to its enormous dealership network, which has more employees than the company itself and boasts a net worth of nearly $23.4 billion.

It's no surprise, then, that Caterpillar is revamping its dealers' network to squeeze more returns out of it: It is targeting an incremental $9 billion in revenue if dealers hit median quartile performance and nearly $18 billion if they hit top quartile, all within the next four years.Since this additional revenue will come from internal improvements, it could provide great support to Caterpillar's top line if economic conditions weaken further.

Caterpillar's newly opened first Data Innovation Lab. Source: Company website.

Meanwhile, Caterpillar is aggressively restructuring its operations to boost margins, which is partly why operating profit from its construction division climbed 8% in the first quarter despite 7% lower sales.

But the worst could be already over, considering that Caterpillar expects to incur only about $150 million in restructuring costs this year compared to $441 million in 2014. At the same time, management plans to shell out more on research and development this year, substantiating its efforts to invest in the future.

That's not to say Caterpillar has forgotten its shareholders. It increased its quarterly dividend by 17% last year and repurchased a whopping $4.2 billion worth of shares. The company's dividend has more than doubled since 2006. At 14 times trailing earnings, Caterpillar stock appears to be cheap right now, particularly with the stock's dividend yield of 3.3% and analysts' projections that the company's earnings will grow 11% over the next five years. Simply put, if you can stomach Caterpillar's volatility in the near term, it's an excellent stock for anyone who believes in the buy-and-hold strategy.

The article Stocks to Watch in Construction Machinery: Caterpillar Inc. and Terex Corporation originally appeared on Fool.com.

Neha Chamaria has no position in any stocks mentioned. The Motley Fool recommends Terex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.