Construction Equipment Stocks on Holiday Sale

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Though there are several headwinds in the construction equipment market ranging from spending cuts to slowing Chinese growth, momentum has still been strong. Multiples have fallen so low that the downside is relatively limited. But the question then turns to whether these headwinds will prevent meaningful stock appreciation. Below, I review my outlook on 3 construction equipment producers in the space.

Caterpillar on Sale by 40%

At a respective 8.4x and 9.3x past and forward earnings, Caterpillar (NYSE: CAT) is quite cheap at current prices. Growth is nowhere close to being factored into the stock price, as evidenced by the 0.60 PEG ratio. Although the beta of 1.86 would normally be seen as a reason to not invest, in this case, it compels me to recommend the stock even more--it will close the value gap quickly. Just how undervalued is Caterpillar?

Analysts forecast 14% annual EPS growth over the next 5 years. This means 2016 EPS will be around $13, which, at a multiple of 14x, translates to a future stock value of $182, or $113 in present terms. This represents a 40% margin of safety to the prevailing price. 

The main headwind I see to the stock is poor free cash flow management. Over the last 5 years, the company has averaged annual FCF of $3.8 billion. In the twelve trailing months ending 3Q12, Caterpillar generated $1.1 billion. Considering that the company is worth $53 billion, that figure is much too low and will constrain stock appreciation. With that said, ROE has sharply recovered from the 2010 low and 2004 low; it now stands at 42.9%, well above the 5-year historical average of 32.6%. In addition, the President's re-election has also been cited by JPMorgan as a headwind, since it is likely to limit coal and energy activity.

Even still, performance has been strong. In all of the 5 preceding quarters, management exceeded analyst expectations and did so with an average beat of 16.3%. Strangely, however, the stock has fallen by 14.8%. Part of the reason has to do with overblown fears concerning the company's increased exposure in mining end markets and slowing Chinese growth. I find myself in agreement with Morningstar that the underperformance has more to do with a cyclical decline than a long-term secular transition. Coal will still remain a popular energy source in the United States, even though producers are shifting towards natural gas. And the closure of Chinese high-cost mines will provide greater export growth opportunities for domestic miners and thereby help boost Caterpillar's upside.

Diversify With Deere, Joy Gobal

Deere (NYSE: DE) and Joy Global (NYSE: JOY) are other attractive investments to make alongside a holding in Caterpillar. They trade at a respective 11.4x and 7.8x past earnings and come off of double-digit EPS growth during the past 5 years. Over the past 3 months, Deere has outperformed with a return of 12.9%, nearly 2,050 basis potions greater than Caterpillar's. Can it do it again?

The ag equipment producer has several catalysts going for it. First, it has been an excellent performer--exceeding analyst expectations several times in the last few quarters. The most recent quarter was a miss, but it was largely due to one-time events that, of course, have no bearing on the future. Second, the post-drought surplus of farming activity has yet to be realized. Sales for 4WD tractors are thus exposed to a recovering market that has already outpaced peers. I thus strongly encourage an investment in Deere.

Joy Global looks less promising but still undervalued. Free cash flow has fallen precipitously from $571 million in April of 2011 to less than $200 million today, which yields 3.4% against the current market cap. Even still, the consensus price target on the Street is $70.26 with the most recent report by Barclays pegging the stock at $88, a more than 60% premium to the current market assessment.

With forecasts for 16.5% annual EPS growth over the next 5 years and double-digit earnings growth over the past 5 years, it's hard to not see multiples rising from the 7.8x level. Performance may have missed expectations by 5.8% in 2Q12, but emerging market growth, particularly in coal, has been underappreciated--like it has for Joy. Thus, investing in all three of these companies is ideal.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Joy Global. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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