March 26 (Bloomberg) -- Hennes & Mauritz AB, Europe’s second-largest clothing retailer, reported its first quarterly profit drop in more than five years as the strengthening dollar cut into margins and the economic contraction deterred shoppers.

The shares fell the most in three weeks after H&M said first-quarter net income slid 12 percent to 2.58 billion kronor ($320 million), missing the 2.98 billion-kronor median estimate of nine analysts. Sales at stores open at least a year declined 8 percent in February, the seventh straight drop, H&M also said.

The dollar’s strength against the euro added to the cost of buying clothes in Asia, where many monies are tied to the U.S. currency. The gross margin narrowed by 3 percentage points to 56.6 percent in the quarter, H&M said. Excluding currency effects, the margin would have widened to 60.8 percent, it said.

The “market had understood from the company at the time of the full-year results in January that the currency risk to the gross margin had been hedged away,” Societe Generale analyst Anne Critchlow said in an e-mailed note. “It turns out that 10 percent of buying was unhedged and it was this exposure that caused much of the fall in the gross margin.”

H&M fell 11.5 kronor, or 3.5 percent, to 316.50 kronor in Stockholm trading, the steepest drop since March 6.

The reduced margin has “negative implications” for profit estimates and is “a deep shock to the market,” Critchlow said.

Stronger Dollar

The dollar on average was worth 11 percent more against the euro in the quarter compared with the same period a year ago.

H&M, which sells $17 cardigans and $20 chinos, said today it remains “positive” about expansion and “business opportunities.” The Swedish retailer has appointed Karl-Johan Persson as chief executive officer from July, putting operation of the company back into the founding family’s hands, after current CEO Rolf Eriksen said he’d retire in September.

“In view of the current economic environment and the negative currency effects” the company “considers the operating result for the first quarter as good,” H&M said.

First-quarter same-store sales fell 5 percent as slowing economies from Europe to the U.S. led to weaker consumer demand.

Total revenue rose 18 percent to 23.3 billion kronor. The Swedish retailer opened 13 stores in the period and had 1,748 outlets at the end of February, up from 1,529 a year earlier.

H&M, which ranks as Europe’s most valuable retail brand according to Interbrand, still plans to add 225 stores this year, it said today. During the second quarter, the retailer expects to open 74 shops and close seven.

Larger rival Inditex SA said yesterday it will continue expanding its low-cost Zara fashion chain to take market share from more expensive brands in the recession.

H&M’s first-quarter profit declined from 2.94 billion kronor in the same period a year earlier.

To contact the reporter on this story: Meera Bhatia in Oslo at mbhatia2@bloomberg.net.

Last Updated: March 26, 2009 13:12 EDT