BAE shares are tanking. Here’s what I’d do now

6%. This is how much the BAE Systems (LSE:BA) share price has dropped in only four days.

Moreover, it’s still down 26% from its pre-corona crash peak on 21 February.

And, it’s lower than the assigned fair value of some analysts of 570p. Indeed, back in January, other analysts advised investors to hold the stock at 671p.

BAE stock already looks undervalued.

So, why’s the price still dropping, and what should I do about it?

The recent movements in BAE shares 

Quite frankly, I think BAE was caught in Monday’s FTSE plunge as markets feared a second coronavirus shutdown. Unfortunately for BAE, this news overshadowed its Archfish contract renewal with the US Navy.

Ironically, the defence manufacturer’s news of a $1bn debt issue coincided with a rise in its share price only one week earlier.

BAE’s debt is already substantial but the markets, and ratings agencies, appear buoyed by its funding of two new strategic acquisitions, Collins Aerospace Military Global Positioning Systems and Raytheon’s Airbourne Tactical Radios.

BAE is expecting these market leaders to improve its own electronic systems offerings. In turn, this is a high priority area for US defence spending and should help BAE to continue to offer innovative capabilities to its markets. 

Debt and the dividend yield 

Despite the new debt issue not affecting BAE’s credit rating, moving forward the firm will be expected to reduce its debt pile if it wants to maintain its rating. I think BAE is expecting its new acquisitions to help provide some of the cash flow to do this.

However, it’s likely shareholder returns will be examined too. BAE currently offers a relatively impressive 4.6% dividend yield.

A yield of this size from a company with long-term stable cash flows is highly attractive. The nature of BAE’s business means it has many long-term government-funded contracts, including building the UK’s Type 26 frigate and a stake in Lockheed Martin‘s F-35 Joint Strike Fighter.

This type of business provides stability in both earnings and dividends.

However, I think the current dividend yield will be reduced to pay down debt. BAE has limited room for manoeuvre here and shareholder returns will likely be a prime target.

But, for shareholders, there may be capital gains to be had later.

BAE is strongly positioned for further growth. The damage from the Covid-19 shutdown isn’t as bad as feared, and the firm secured $9.3bn of new orders during the first half of this year, making a total order backlog of $46.1bn.

BAE is expecting the second half of this year to be stronger, with overall increases in both revenues and earnings. Despite an expected slowdown in US defence spending, with its new acquisitions BAE is aligning its US businesses to American defence priorities. I’m hopeful this will pay off in the long-run.

BAE on sale

I like the fact that BAE shares are on sale right now. Yes, I think the firm is too heavily indebted. But, it is already implementing measures to deal with it. Its new acquisitions appear strategically aligned and it has a stable dividend, albeit there’s a possibility of it being lowered.

Overall, BAE shares are selling at a good price. There are returns to be made. I’m buying.