H&M May Post Third Straight Drop in Profit as Labor Costs Soar

H&M May Post Third Straight Drop in Profit
Stockholm-based H&M sources a larger percentage of goods from Asia, where wage inflation is outpacing Europe. Photographer: Linus Hook/Bloomberg

Hennes & Mauritz AB may report a third straight decline in quarterly profit tomorrow as the maker of $4.95 tank tops wrestles with higher labor costs in Asia, pushing it further behind larger rival Inditex SA.

It would be the first time in at least a decade that profit fell for three consecutive periods. Second-quarter net income probably dropped 16 percent to 4.37 billion kronor ($678 million), according to the average of 16 analyst estimates. Profit may also fall about 10 percent in the current quarter.

Stockholm-based H&M sources a larger percentage of goods from Asia, where wage inflation is outpacing Europe, than Zara-chain owner Inditex. Having more suppliers in Europe also means Inditex, the world’s biggest clothing retailer, is able to roll out products more quickly to its stores in the region. H&M has reduced prices, eroding profitability amid record cotton costs.

“H&M and other retailers have benefited from cheaper labor for years, but this year that is starting to change,” said Simon Irwin, a London-based analyst at Liberum Capital. H&M’s profit rose more than 10 percent in every year from at least 2001 until 2009, according to Bloomberg data.

Shares of Inditex, which overtook H&M as Europe’s biggest clothing retailer in 2005, have risen 7.7 percent this year, while H&M has declined 5.9 percent. H&M is still more expensive, trading at 21 times estimated earnings compared with 20 times for its Spanish rival. Fifteen of 35 analysts who cover H&M have a “sell” rating on the shares, while two-thirds of the 33 who follow Inditex have a “buy” rating, Bloomberg data show.

Asian Sourcing

“Inditex has delivered better performance than H&M over the past months,” said Virginie Blin, an analyst at Alphavalue in Paris. The Arteixo, Spain-based company this month posted a 10 percent jump in quarterly profit. “The advantage of its integrated process is that it provides speed and flexibility, enabling it to fine-tune its offer with the latest fashion trends and to optimize promotions.”

H&M, which doesn’t own factories, sources about 75 percent of its clothes from Asia and 35 percent from China alone, said Anne Critchlow, an analyst at Societe Generale in London. Annual pay inflation in China is about 10 percent, she said. Hourly manufacturing wages in China rose 89 percent between 2005 and 2010 and tripled in India in the same period, according to Euromonitor International.

Hourly manufacturing wages in Spain rose 17 percent between 2005 and 2010, according to Euromonitor. Average wages aren’t currently rising in the country, Critchlow said. Inditex gets about 17 percent of its clothing from Chinese suppliers and sources a higher proportion closer to its Spanish distribution centers, according to Critchlow.

Gap Inc., which H&M overtook last year in sales, said this month that cost inflation is the worst in 30 years.

Missing Estimates

Same-store sales at H&M, which last year had a collection designed by fashion house Lanvin, have missed analysts’ estimates for all but one month this year, according to analysts at JPMorgan Chase & Co. Lower prices haven’t stimulated business as much as the company expected, while underperformance in the biggest markets and weaker-than-expected sales in new markets may indicate a “brand issue,” they said.

“H&M has focused too much on the product and forgotten about the rest, which was why it was so successful in the first place,” said Armando Branchini, vice-president of Milan-based consulting firm Intercorporate. “Inditex has a no-frills model, but incredible attention is paid to every aspect from the merchandising to the stores.”

Some investors remain optimistic on the outlook, pointing to the benefits of the retailer’s scale in sourcing from overseas and the prospect of an easing in cotton prices.

“We are confident that H&M can execute its plans and return to double-digit growth,” said Wendy Trevisani of Thornburg Investment Management Inc. in Santa Fe, New Mexico. “H&M started outsourcing early and has huge scale advantages. The situation could reverse very quickly for the better.”

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