H&M is caught in a 'vicious cycle' of discounting, and now it's found itself with a mountain of unsold clothes - here's how it got there

• Operating profit at H&M decreased 62% in the first quarter of 2018, following its biggest sales drop on record in the fourth quarter of 2017.
• The retailer is increasingly losing out to fast-fashion competitors such as Zara and ASOS, which have sped up their supply chain to stay on top of trends.
• The company now has a massive inventory problem with over $4 billion worth of unwanted clothing.

H&M was once considered to be the king of fast-fashion retail, churning out cheap and fashionable clothing to a willing audience. Sales boomed at the company throughout the early to mid-2000s, and it expanded at a rapid rate, opening thousands of stores around the world.

But the tide has begun to turn for the world's second-largest clothing retailer. Over the last two years, it has increasingly lost out to more fashionable rivals like Zara at the same time it has been outsmarted by online-centric stores, such as ASOS, that have cut down supply chains to as little as a week.

These pressures are showing up in the company's earnings. Sales growth at H&M started to falter in 2016, culminating in its biggest sales slump on record in the last quarter of 2017. Its share price slumped, and key investors began selling off stock.

On Tuesday, in the company's most recent earnings results, the grandson of the company's founder and its current CEO, Karl-Johan Persson, acknowledged H&M's troubles but left investors wondering what exactly management is doing to resolve them.

"The start of the year has been tough," he said. "2018 is a transitional year for the H&M group, as we accelerate our transformation so that we can take advantage of the opportunities generated by rapid digitalization."

What went wrong?

Analysts claim that H&M has a brand issue. It's not the cheapest, it's not the best quality, nor is it the most fashionable store, and it's increasingly being left behind because of this.

"The offering is the core problem," Erik Sjostrom, a fund manager at H&M shareholder Skandia, which has sold off considerable amounts of its stake in the company, told Bloomberg in February.

"The fashion, the price, the distribution. I believe they are off both in terms of fashion and price," he said.

Trendy online stores such as ASOS and Boohoo are beating H&M both on price and speed. They've cut down their supply chain times to between one and eight weeks, allowing them to stay right on top of trends. Brick-and-mortar rival Zara has a similarly speedy five-week turnaround and is known for its fashionable offerings. Meanwhile, H&M lags behind with a six-month turnaround time.

The store has also suffered from shopping habits increasingly shifting online, an area where it lags behind.

"H&M was fast into online in the late 1990s but has been stuck with legacy infrastructure in some established markets. It has been working on adapting its IT infrastructure to support the business, but this has taken time and led to some teething problems," RBC analyst Richard Chamberlain wrote in a note to investors in January.

Persson is aware of the company's shortcomings, and growing the digital business is at the crux of the company's comeback strategy. In several recent earnings reports, Persson said that he is expecting online sales to grow 25% in 2018.

Inventory: the elephant in the room

As fashion-conscious customers have headed elsewhere for the latest designs, discounted clearance sections have become a common feature of H&M stores.

In the third quarter of 2017, Persson blamed lower profits on aggressive sales but said these had helped to clear inventory and put the store in a good position for the next quarter. This didn't happen - clearance sales continued throughout the final quarter of the year and into 2018.

"Weak sales in the fourth quarter, partly caused by imbalances in the assortment for the H&M brand, resulted in the need for substantial clearance sales in the first quarter," Persson said in a note to investors on Tuesday.

He added: "The high level of clearance sales combined with unusually cold winter weather had a negative impact on the sales of the spring garments."

But these sales don't seem to be rescuing the company from a mounting inventory crisis. It currently has over $4 billion worth of unwanted clothing and analysts are skeptical as to how the company will get rid of this.

"We remain unclear as to how H&M is going to trade out the inventory mountain without doing further damage to full price sales," Credit Suisse analysts wrote in a note to investors in February.

"The company seems to have no obvious strategy for escaping the vicious cycle of poor sales, higher markdown, and excess inventory," the same analysts wrote in an update in March.

A spokesperson for H&M told Business Insider that the unwanted stock mainly consists of new spring or summer items, sales of which have been delayed by unseasonably cold weather. The rest of it is "season-less garments," which can be "sold all year round" the spokesperson said.

"Every snapshot of the inventory contains a lot of new products that are on their way on ships, and in our distribution and replenishment centers. Just a small part is actually in the physical stores," they added.

When we visited an H&M store in Soho, Manhattan, this month, we found that there were several clearance racks dotted around the store. These racks had a mix of clothing from different seasons, including tank tops, skirts, and woolen jumpers, for example. The rest of the store had a 20%-off sale for customers who spent over $75.

"H&M continues to be aggressive in clearing stock and we think there is a risk that constant promotions are losing their power to drive sales and also question whether the main H&M brand will be tarnished going forward," RBC's Chamberlain wrote in a note to investors in March.

Looking toward the future

H&M's solution to growth has historically been to keep opening stores, but this seems to be slowing somewhat. In 2017, it said it will close more stores than ever before and focus its opening strategy in countries with growth potential, which analysts view as a positive.

There is also more potential for growth with its successful sister brands such as COS, whose profitability is in line with H&M despite having 95% fewer stores. Some analysts argue that it would be wise to convert some of H&M's store space to these brands.

The company is also focusing on improving its supply chain to make it faster and more flexible, which could help it to fight back against competitors.

The biggest issue now is clearing the unwanted stock. In February, the company announced it would launch a new concept in Sweden, called the Afound store, which would sell its products at a discount. This could be a smart way to keep clearance racks away from its main stores and stop them from damaging its image. However, this would need to be done on a larger scale.

"Assuming the group makes further gradual progress to clear its excess stock, this should offer the platform a new and fresh start," Macquarie analysts wrote in a note to investors in December.

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