Japanese construction stocks have rallied after the announcement that Tokyo would host the 2020 Olympics, but the actual impact of the games has been overestimated and the stocks are now overbought, says Citi Japanese equities analyst Shusuke Terada.
Bearish sentiments on Japanese construction
Terada is bearish on the Japanese construction sector, but not because he thinks it is facing a downturn. There was plenty of reason to be optimistic about earnings growth, but the prospect of large orders for the Olympics has given people unrealistic expectations. “Even if profits reach record levels by 2020, shares still do not look undervalued,” he writes.
The main structural challenge facing Japanese construction firms is an acute labor shortage in the face of growing demand. Between an aging population, lack of skilled workers, and pressure from the Ministry of Land, Infrastructure, Transport and Tourism (MLIT) to pay better wages to manual laborers, firms are forced to pay more for labor, In particular, foremen represent a fixed cost that can take a serious cut out of a small project.
In response, firms are moving away from the practice of lowballing for market share and are now focusing on profit over volume. The general tender for the Musashino-no-Mori Comprehensive Sports Facility actually received zero bids because the posted price was too low. The Tokyo municipal government reposted the job this month with a small bump in price.
Expectations for construction margins
“It appears likely that the uptrend in initial prices quoted to customers is likely to continue,” writes Terada. “Over the next two to three years, we expect construction margins for general contractors to approach 10% for civil engineering and 7% for building construction.” Along with growing demand, the overall picture is of a healthy sector with labor issues to resolve.
Investors hope for Olympics in Japan
But respectable fundamentals have been eclipsed by investor hopes for the Olympics. “Even in an optimistic scenario we estimate that Tokyo Olympics benefits will be just 8 percent – 11 percent of overperformance at the major general contractors,” writes Terada. “The shares of Taisei, our least preferred name and one seen by the market as an Olympics champion as it was responsible for the construction of the 1964 Olympics stadium, have rallied 22 percent since the Olympics were awarded to Tokyo.”
Terada estimates that the games will increase demand by about ¥560 billion per year, but the Musashino-no-Mori project, a possible Olympic venue, shows the government is in no mood to spend more than it has to on construction for the games, and the potential to secure future business with a big, symbolic building (see Taisei above) makes Olympic venues coveted contracts, driving down how much contractors can expect to ask. It’s hard to predict how much rising demand will exacerbate the labor shortage, but it will put additional pressure on margins from 2016 – 2020. Taken together, investors are buying too readily into the Olympics story.
“The probability of the Olympics and related developments leading to a sustained economic recovery is low,” Terada concludes.