Zara's Shrinking Profit Margins Expose a Fashion Behemoth

By Jeannette Neumann Features Dow Jones Newswires

Shrinking profit margins at the parent company of Zara have exposed a rare weakness in the armor of a fashion behemoth that has largely resisted the headwinds currently battering the industry.

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Inditex SA, the Spanish company that owns Zara and brands such as Massimo Dutti and Bershka, on Wednesday reported a net profit of EUR2.34 billion ($2.75 billion) during the nine months that ended Oct. 31, a 6% increase from a year earlier. Sales at Inditex climbed 10% to EUR17.96 billion for the period. Like-for-like sales accelerated in the run-up to the holiday season.

But Inditex's gross profit margin declined 30 basis points to 59.4% in the fiscal third quarter from a year earlier.

The full-year gross profit margin at Inditex, whose full name is Industria de Diseño Textil SA, has continued to fall from its fiscal year 2013 peak of 59.8%. While Inditex's profits outstrip those of competitors such as Hennes & Mauritz, analysts and investors have questioned whether the slide at Inditex is due to short-term factors such as currency movements or reflects long-term challenges to its winning model.

The company, the world's largest fashion retailer by sales, sources and produces the bulk of its garments close to home, which allows it to design and deliver new items to stores in as little as two weeks. That rapid-fire turnaround has transformed Zara's parent company into one of the world's most profitable retailers.

But Zara, and Inditex's seven other brands, including Pull&Bear and Stradivarius, haven't been completely immune to the ills affecting American clothing companies such as Gap Inc, and J. Crew Group Inc., which have been hammered by consumers shifting to online shopping.

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Most analysts attribute the shrinking margins to adverse currency moves that they expect to abate in 2018. Analysts at Macquarie Group estimate Inditex's gross margin will begin to rise next fiscal year to 57% and maintain roughly that level thereafter.

"If there is one company which has proven its ability to outperform even in a hostile market environment, this is Inditex," said Macquarie analyst Andreas Inderst.

Investor concerns about profitability have pushed Inditex's shares down 5% year-to-date through Dec. 12, less than the decline of many of its peers. On Wednesday, though, Inditex shares were up around 3% in morning trading in Madrid, erasing some of those losses.

Zara's parent company generates more than half its sales in more than five dozen non-euro currencies, but produces most of its product in Spain, so the weakening of those currencies in comparison to the euro has chipped away at reported revenue in euros.

Inditex executives said Wednesday that without the negative currency impact, the gross margin would have increased in the fiscal third quarter, but they declined to say by how much.

A few analysts, however, think price cuts aimed at buoying sales have hurt Inditex's margin. They also believe sales at stores open at least a year are no longer offsetting the cost of increasing online sales. Online sales, they say, are less profitable than those at brick-and-mortar stores because of the added cost of delivery.

"While we retain our admiration for Inditex's business model, our confidence in the sustainability of exceptional revenue growth is declining as competition mounts," Berenberg Bank analysts wrote in a research report.

Inditex executives say the company is constantly adjusting prices but says it doesn't have a strategy of slashing prices of its cheapest garments. "Our pricing policy is very much stable in all the different geographies," Inditex Chairman and Chief Executive Pablo Isla told analysts Wednesday.

Société Générale conducted an extensive study on Zara's prices in 10 countries and found that the retail giant had in fact cut its lowest prices in 2017 compared with 2016 but that Inditex was also raising its top-end prices to widen its appeal and boost sales.

Write to Jeannette Neumann at jeannette.neumann@wsj.com

(END) Dow Jones Newswires

December 13, 2017 05:14 ET (10:14 GMT)