Caterpillar (CAT 0.59%) undoubtedly faces headwinds in 2022, and some of them could get worse going into 2023. On the other hand, management is making excellent progress on its strategic objectives, and investors can feel more confident in its long-term prospects. It's a classic investment puzzle, and the bull and bear debate over the stock is likely to be fierce. So, should you buy a stock with near-term risk, even if it has a long-term opportunity?

Caterpillar in 2022

The answer to the question lies in understanding what's happened to Caterpillar this year, what to expect going forward, and how it's relevant to the company's strategic objectives. 

In a nutshell, Caterpillar's volatile stock price this year (up firmly in the spring, down in the summer) reflects the changing sentiment in its end markets. Within machinery, Caterpillar is best known for its construction equipment (key end markets include non-residential, residential, and infrastructure). However, it also has a large resource industries segment (mining and aggregates mainly used in roads), and investors shouldn't overlook its energy and transportation equipment (oil & gas, power generation, industrial gas turbines, locomotive engines) segment either. 

A mix of businesses made Caterpillar an attractive stock in the spring when industrial metals, minerals, and energy soared and non-residential construction continued its recovery from the pandemic. Unfortunately, it's also a mix of businesses that had investors concerned when those self-same commodities fell sharply in the summer. Meanwhile, a slowing U.S. residential construction market, as well as slowing growth in China (particularly in construction), threatens Caterpillar's outlook. 

These themes are reflected in Caterpillar's earnings

All these industry trends were discussed in Caterpillar's second-quarter earnings presentations. Management talked of its mining and energy customers being disciplined in spending, a deteriorating market for large excavators in China, and a moderating U.S. residential market. Meanwhile, CFO Andrew Bonfield told investors, "Manufacturing costs were also slightly higher than expected, primarily due to continued material and freight cost pressures as well as the impact of supply chain on our factory performance." In fact, manufacturing costs wiped out $966 million from operating profit compared to the second quarter of 2021.  

Moreover, Bonfield noted that "Machine sales to users were impacted by supply chain challenges was slightly worse than we had anticipated" and "the ongoing supply chain constraints continue to impact our ability to ship equipment."

In other words, Caterpillar continues to suffer from the supply chain dislocations that have negatively impacted global growth this year. 

It all added up to a second quarter when, excluding corporate items and eliminations, Caterpillar's machinery and energy and transportation (the non-financial part of the company making up the overwhelming bulk of sales) segmental profit would have fallen by $72 million compared to the same quarter in 2022. 

Whichever way you cut it, it was as challenging a quarter as investors had expected it to be, and there's no guarantee it won't get worse as the economy slows. 

Three reasons to be optimistic over Caterpillar stock

With all that said, Caterpillar is making progress on its objective to reduce cyclicality in its business by increasing its services and aftermarket parts revenue. For example, strong growth in services helped to overcome weakness in machinery sales (due to supply chain pressures), and CEO Jim Umpleby said, "our confidence is increasing that we'll achieve our goal to double services to $28 billion by 2026." For reference, analysts expect Caterpillar to hit $57.5 billion in sales in 2022. 

Caterpillar is also doing a great job of offsetting increased costs. Going back to the increased cost of $966 million discussed above, increased pricing more than offset it with a $1.1 billion increase in the second quarter.

Finally, Umpleby confirmed Caterpillar would be within its targeted range of $4 billion to $8 billion in machinery, energy & transportation free cash flow (FCF) for 2022. Caterpillar's management recognizes the inherent cyclicality in its business (although it's reducing it by growing its services business) and gives a target of $4 billion to $8 billion (as above) to reflect that. 

Is Caterpillar stock a buy?

Growing services revenue and pricing power demonstrate that Caterpillar will likely emerge as a stronger company out of a recession. Moreover, if $4 billion is a floor in its cyclical FCF, then, based on the current price, the trough price to FCF multiple will be almost 26 times FCF, and the peak will be 13 times. 

It's a good set of figures, but if you buy in, you should prepare for some volatility and potentially bad news over the near term. Moreover, after a solid recent run, Caterpillar's stock looks fairly valued on a risk/reward basis, making it hard to justify piling into the stock right now.