There are no two ways about it: Caterpillar (CAT 0.82%) is a cyclical company. Its revenue and earnings tend to rise and fall in sync with the general trends in the global economy.

So everyone shouldn't be surprised then that Caterpillar faces some near-term risks from a slowdown in the global economy, not least from a cooling construction market in China. That said, investors don't just buy stocks as short-term bets on the economy. Also, there's reason to believe Caterpillar will emerge stronger from a recession, should it happen. Let me explain.

Management's strategy gets tweaked

The cyclicality in Caterpillar's earnings is implicitly recognized in management's targets. For example, back in its 2019 Investor Day presentation, management told investors to expect its annual machinery, energy, and transportation (ME&T) free cash flow to be in the range of $4 billion to $8 billion during the current cycle, in contrast to the $3 billion to $6 billion it achieved during the 2010-2016 cycle. Moreover, management is aiming for its adjusted operating margin to be in the 10% to 21% range, with a 300 basis point to 600 basis point improvement on the margins achieved in the 2010-2016 period.

The width of those ranges is a recognition of the cyclicality of its end markets and an affirmation that management sees Caterpillar's underlying businesses as strengthening through the next up and down cycle. 

So far, Caterpillar has largely hit its 2019 targets, with adjusted operating margins of 15.8%, 11.8%, and 13.7% in 2019-2021. Over the same period, its annual ME&T free cash flow results were $5.3 billion, $3.1 billion, and $6 billion, so Caterpillar missed its target in 2020, but during the 2022 investor day presentation, CEO Jim Umpleby explained that "was largely due to our strategic decision to hold more inventory than usual to prepare for a potential increase in demand in 2021."

Services growth

Caterpillar has been improving profit margins and free cash flow through this cycle by growing its services revenue. Management aims to double its services sales from $14 billion in 2016 (on total sales of $38.5 billion) to $28 billion in 2026. Caterpillar is on its way with $19 billion in services sales in 2021 (on total sales of $51 billion). It plans to hit its target by building out its digital strategy. Its predictive analytics help customers better plan when to service equipment, which reduces their costs. Its fleet management tools allow customers to track and monitor equipment. At the same time, its digital platforms help customers to order parts -- and Caterpillar's online parts sales were up more than 20% in 2021 alone. It's all intended to maximize the company's revenue opportunities after it has sold equipment to a customer.

This growth in its services business will put Caterpillar in a stronger position for the period when the global economy starts shifting out of a recession. 

The energy transition 

Management also believes Caterpillar will be a beneficiary of a secular shift in the economy as nations around the world transition to greener energy sources. Not only will that shift demand significant infrastructure to be built -- good news for Caterpillar's construction machinery business -- but it will also create growth opportunities as demand increases for mined commodities. During the 2022 investor day presentation, Umpleby said, "To expand upon one example, the adoption of electric vehicles is accelerating demand for key commodities. EVs use approximately six times the minerals of a conventional car, including copper, lithium, nickel, and graphite." That's excellent news for Caterpillar's resources industries business. 

A long-term commodity upcycle?

The third argument in favor of this stock is that the more disciplined approach to spending taken by oil and gas and mining companies in the current environment supports relatively higher prices and, ultimately, a long expansion of their spending. This differs from the prior pattern of violent booms and busts in these industries, where excessive production has led to gluts of oil and other commodities when demand declines. 

That's good news for Caterpillar because it allows management to better plan its production from year to year. 

A stock to buy?

These arguments are attractive, and Caterpillar will surely emerge as a stronger company from a recession. However, investors will have to deal with significant volatility if a recession occurs, and at its current valuation, the company looks fairly valued. As such, this stock is one for the monitor list right now rather than an outright buy.