STOCKHOLM (Reuters) - Cost controls helped H&M HMb.ST to limit a drop in quarterly pretax profit but the fashion chain said it was increasing investments this year as it tries to keep pace with its larger rival, Zara owner Inditex ITX.MC.

FILE PHOTO: People walk past the windows of an H&M store in Barcelona, Spain, December 30, 2016. REUTERS/Regis Duvignau/File Photo

H&M, the world’s second-biggest fashion company, said conditions remained very tough in key European markets and in the United States, with shopping behavior and expectations changing rapidly.

Earnings were dented by weaker than expected sales growth and bigger mark-downs and H&M shares fell 5 percent.

After years of hectic expansion across the world, the Swedish company's profitability has faltered as Inditex, Fast Retailing's 9983.T Uniqlo and online specialists such as ASOS ASOS.L gain an edge in "fast fashion". By turning over more new styles each year and having production closer to customers, they can quickly boost supplies of best-selling items.

H&M’s supply chain lead times are around double those of Inditex, according to a report this month by Goldman Sachs, which recommended that investors “sell” H&M shares.

H&M Chief Executive Karl-Johan Persson conceded that the company’s supply chain practices had remained the same while the world had changed. H&M would “definitely” move some production closer to end-markets while keeping an eye on profitability.

“Some is about moving to Europe as well, it could be Turkey or other countries in Europe, in order to get faster deliveries to Europe,” he said. The company would also seek more flexibility with suppliers so it needs lower inventories and boost spending to make the supply chain more flexible.

DILEMMA

H&M has seen competition and price pressure in its budget ranges increase from rivals such as Britain's Primark ABF.L, which recently entered H&M's biggest market Germany.

H&M is also branching out to reach a broader customer base and cut exposure to the budget segment. On Thursday it announced a new chain of stores, ARKET, with a slightly higher price range than its core budget H&M brand.

The new chain would also sell brands made by third parties.

But H&M has a dilemma -- the need to compete on price means four fifths of its production is in Asia, far more than Inditex which sources around half its products from countries close to its main markets, allowing it to react faster to sales trends.

More of Inditex’s clothes are ordered, produced and delivered in-season, on demand, from nearby factories within weeks so it can capitalize on the constantly shifting preferences of young, fashion-conscious shoppers.

H&M’s further-flung supply base could also leave it more exposed to trade disruption from protectionist moves such as Britain’s decision to leave the European Union and the election of U.S. President Donald Trump.

“While we don’t know if imports or exports will change for either, or other, countries at this point, if they do create significant impacts, that could change the dynamics of production for many retailers in the long term,” said Kantar Retail consultant Tiffany Hogan.

Large markdowns in stores last year hit sales and highlighted shortcomings in design and supply planning. Thursday’s results further underscored the need for H&M to become more responsive to consumer tastes.

Societe Generale analyst Anne Critchlow said H&M’s gross margin -- its most basic measure of profitability -- was higher than expected in its financial quarter that runs from December to February.

But she said March sales, which rose 7 percent on a constant currency basis, looked disappointing, “even taking into account the later Easter this year”.

She highlighted a 30 percent increase in inventory compared to a year earlier and the company warned of a risk of increased mark-downs impacting its gross margin if that stock-in-trade is not sold down over the months ahead.

Quarterly pretax profit fell to 3.21 billion crowns ($362 million) from 3.33 billion a year-earlier, above a mean forecast for 2.87 billion in a Reuters poll of analysts, helped by cost controls and currency translation effects.

STOCK CHECKING

H&M shares have lost a third of their value since reaching an all-time high two years ago. In January, H&M was dethroned by financial services company Nordea NDA.ST as Sweden's most valuable listed company.

Overhauling H&M’s supply chain model to mirror that of Inditex could be a major logistical challenge and incompatible with H&M’s lower-than-Zara price point as production in Europe is more costly than in Asia.

H&M managers are focusing much of their energy on warehouse automation, meta-data analysis and RFID clothes tagging so staff can know where clothes are and move quicker to address shortages or oversupply.

It aims to get RFID tagging, which allows stock checks in less than a sixth of the time it used to take, up and running next year. Inditex already uses it across its Zara operations.

“I think it’s more important that H&M keep tabs on their shopper and be able to deliver strong assortments via shopper data and analysis,” said Kantar Retail’s Hogan.

“H&M need to make sure they’re innovating ahead of the curve, not just to catch up,” she added.