H&M feels the pinch as strong dollar hikes sourcing costs

By Helena Soderpalm and Anna Ringstrom

STOCKHOLM (Reuters) - Sweden's Hennes & Mauritz (HMb.ST), the world's second-biggest fashion retailer, warned on Thursday it expects the strong U.S. dollar to translate into rising sourcing costs throughout the year after it hurt second-quarter profits.

H&M, which has benefited from low-cost garment production in Asia to grow to 3,639 stores in 59 markets, said it suffered in the March-May quarter from higher input costs, largely due to the dollar.

It said the situation could be even worse for its third and fourth quarters, noting it would still ensure "it has the best customer offering in each individual market", implying it is unlikely to pass on those costs by raising prices.

H&M, which buys the bulk of its clothes in Asia on U.S. dollar contracts while selling most of them in Europe, is more exposed to the strong greenback than bigger rival Inditex (ITX.MC), the Zara owner which produces more garments in house and sources the majority of them in or near Europe.

And it is harder for the budget brand to pass on costs by raising prices as it faces growing competition from discounters like Primark (ABF.L) and Forever 21, which pose less of a threat to mid-market brand Zara.

Aside from the impact of the dollar, H&M input costs are broadly neutral, with cotton prices falling but salaries for factory workers on the rise, Chief Financial Officer Jyrki Tervonen told a call for analysts.

MARGIN SQUEEZE

H&M's gross margin shrank more than expected in the quarter to 59.4 percent from 60.8 percent a year ago, missing a mean forecast in a Reuters poll of analysts of 59.9 percent.

Inditex' gross margin, meanwhile, expanded in its fiscal quarter through April to 59.4 percent from 58.9 percent.

H&M's shares were down 3.7 percent by 1353 GMT, making them the biggest loser in the European retail sector (.SXRP).

"The outlook for the next 12 months in relation to currency movements is far more favourable for Inditex than it is for H&M," said Societe Generale analyst Anne Critchlow, who rates H&M shares "hold".

"We think Inditex will prove to be the much stronger story, for the remainder of this year, into next year and beyond, particularly with regard to margin outlook," she said.

While H&M shares are up about 2 percent this year, Inditex has soared 29 percent to trade on 31 times forward earnings, opening up a big premium to H&M on 23 times.

INVESTING IN NEW BRANDS

H&M is responding to its challenges by investing heavily in e-commerce and higher-end brands such as COS, as well as producing new ranges like a beauty line to be launched in July, a fact that is also weighing on margins.

Chief Executive Karl-Johan Persson told Reuters H&M could be ready to launch another new brand in 2017, standing by plans to increase investments, albeit at a slower pace than in 2014.

"We see them as necessary in order to build an even stronger H&M," he said.

By contrast, Inditex has said it expects to trim investment in 2015 after making major outlays on logistics to help it grow online. It has slowed store openings, closing smaller shops in favour of big flagship sites to complement e-commerce sales.

H&M targets a 10-15 percent annual increase in the number of stores, with 400 openings planned for 2015. Persson said the firm may adjust the target to reflect the fact it now has several different brands and the rising importance of online.

"It's not about there not being any more expansion potential left, it's just about making it a little more relevant," he told Reuters, without elaborating on how the target could change.

Inditex aims to add 8-10 percent store space each year.

H&M had already reported sales rose a better-than-expected 10 percent in local currencies, despite unusually cold spring weather in many European markets.

On Thursday, it said sales have accelerated since then, rising 14 percent in local currencies to June 23. Inditex has also seen sales picking up recently, rising 13.5 percent from Feb. 1 to June 7 in local currencies.

(Reporting by Helena Soderpalm and Anna Ringstrom; Editing by Emma Thomasson, Greg Mahlich and Peter Graff)