There are no prizes for guessing the main reason for the 3% decline in Caterpillar's (CAT 1.59%) share price to late afternoon today. Higher-than-expected inflation data dampened hopes for an early interest rate cut, and that's not good news for highly cyclical stocks like Caterpillar.
Caterpillar's cyclicity
The company is often seen as highly sensitive to the economy due to its exposure to construction (an activity that decreases as the cost of borrowing rises), mining (industrial metals rely on the economy for demand growth), and energy and transportation.
These facts are recognized in management's guidance, which calls for free cash flow (FCF) generation of $5 billion to $10 billion through the cycle. In other words, when the economy is firing on all cylinders, Caterpillar expects to generate $10 billion in FCF, while when it hits a trough, the company should generate no less than $5 billion. As such, the longer interest rates stay relatively high, the more pressure there will be on Caterpillar's earnings.
Caterpillar is an outstanding stock to buy on a dip
That said, while the economy isn't firing on all cylinders, the company is. For example, the company more than offset declining sales volumes in the fourth quarter with excellent pricing action -- a sign of real pricing power in its products.
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Moreover, the $23 billion in services revenue in 2023 (compared to total revenue of $67 billion) helps the company reduce its revenue cyclicity, as services revenue is more sticky in a downturn. Management intends to hit $28 billion in services revenue by 2026.
It all points to a company executing at a high level. While the market sees the potential headwinds in its business from interest rates staying at the current level for a while, Caterpillar is the kind of stock that could do well when rates fall -- not least because it's making the most of challenging end markets right now.
