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Zara owner Inditex faces headwinds but still outruns rival H&M

For nearly a decade, the world's second-largest clothing retailer, H & M Hennes & Mauritz AB (publ) of Sweden, has been nipping at the hem of its bigger rival Industria de Diseño Textil SA of Spain, owner of the Zara fashion brand. On the latest evidence, it is still struggling to catch up.

Inditex, which owns eight brands including Pull&Bear and Massimo Dutti, generates more revenue, operates more stores and has delivered a much stronger stock-market performance over the last five years. A close look at another key measure, operating margin, not only explains how Inditex is striding ahead of H&M but also why it could continue to do so for some years to come.

Operating margin is the profit left over after paying for raw materials and expenses such as transport and wages. The higher the operating margin, the lower the financial risk. Fast-fashion retailers continually plow large sums of money toward new designs, brick-and-mortar stores and e-commerce, so the operating margin figure reflects not just sales but also costs.

Back in 2008, H&M's operating margin of 22.7% was well above the 15.7% reported by Inditex, according to an analysis by S&P Global Market Intelligence. Within three years, Inditex had caught up, and for the following seven years, its operating margin ranged from 16.7% to 19.5%. H&M's, by comparison, fell almost continuously and hit a low of 7.4% in 2018.

The reason for Inditex's performance isn't a secret. "Operating expenses are tightly under control," explained Pablo Isla Alvarez de Tejera, executive chairman and CEO of Inditex, on a March 13 call with analysts to discuss 2018 results. "They have grown just 4% ... demonstrating the efficiency we are achieving in the business."

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Inditex and H&M declined to make anyone available for an interview.

The focus on costs is important because revenue growth — the other factor in operating margin — has slowed at both companies. H&M's year-on-year revenue growth fell to 1.4% in 2018 from 20% in 2015, while Inditex's revenue growth declined to 3.2% from 15.4% over the same period. The companies also face intense competition from online-only retailers including Amazon.com Inc., Asos PLC of the U.K. and Zalando SE of Germany. And Inditex, in particular, generates a large chunk of its sales in non-euro currencies and has felt the pinch of currency fluctuations in some emerging markets.

Nonetheless, the Spanish retailer is sharper at controlling costs. For instance, it largely eschews advertising. Over the last decade, its gross profit margin — the percent of revenue remaining after deducting the cost of goods sold — hovered between 55% and 60%. H&M's gross profit margin, meanwhile, dropped from 61.5% to 52.7%.

Inditex especially benefits from selling a lot of clothing at full- or near-full price. Unlike most retailers, it chose not to discount its products in the competitive three-month period leading up to Christmas 2018. By contrast, H&M has been under pressure to lower prices to get rid of excess inventory. It is also wrestling with high logistics costs, which led to an earnings miss for fiscal 2018.

"We rate Inditex as a 'buy' as we think earnings before interest and taxes could inflect positively in FY20," said Fred Speirs, an analyst at UBS, in a research note published in February. "We rate H&M 'sell' as we think a rising investment level will be required to defend its market share position." H&M's share of the global apparel market is 1.6% compared to 1.2% for Zara, according to UBS.

Both retailers continue to invest heavily in brick-and-mortar stores and their online businesses but have different emphases. Over the last decade, Inditex has expanded broadly, including in China. As of Jan. 31, it operated nearly 7,500 stores globally, although in the U.S. it relies heavily on flagship Zara stores in key locations. H&M was much slower to expand outside Europe but now operates about 580 stores in the U.S., a far larger footprint than its closest global peers, says Speirs.

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In recent months, H&M has shown signs of a turnaround. In March, the company's share price rose 12% after it reported quarterly earnings that beat expectations thanks to increased full-price sales, lower markdowns and higher market shares.

For now, Inditex retains its edge thanks to a lean and nimble supply chain that churns out 65,000 new designs each year. Nearly 60% of its suppliers are near its headquarters in Arteixo, northern Spain, and 11 of its factories are in that town, too. Mere hours after a new design is flaunted on a catwalk, the information reaches members of a 700-strong design team who quickly get to work on their own sketches using computer-aided software. The designers also get constant feedback from company stores and sales teams about trends causing the biggest buzz.

While the final prototypes are being chosen in terms of style, fabric and color, a separate team of planners estimates production costs, available capacity and pricing. Design specifications are sent electronically to cutting machines at a production facility, and the finished clothes are shipped from 10 logistics centers, all in Spain. It usually takes three weeks for a new piece of clothing to go from drawing board to shelf, according to Inditex, with new styles arriving in stores twice a week. That is far quicker than the industry's average turnaround time of six months.

H&M operates differently. It makes a large amount of its clothes in advance and launches only some in response to short-term market trends. Unlike Inditex, "H&M Group does not own any factories; we collaborate with around 800 suppliers in 20 production markets," a spokeswoman for the company said in an email. The spokeswoman noted that each major H&M brand has its own design team in several cities, including Stockholm, Paris and Los Angeles. Every year, it produces tens of millions of items and distributes them to nearly 5,000 stores worldwide — an equally impressive logistical feat that keeps the fast-fashion wheel spinning.

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