(Bloomberg Opinion) -- That pile of unsold clothes at Hennes & Mauritz AB just keeps on growing.
The retailer said its inventory level reached $4.4 billion on May 31, up from $3.9 billion a year ago.
But look past all those unwanted off-the-shoulder dresses and denim cut-offs, and the drop in pre-tax profit, which reflected the strength of the U.S. dollar and investments in stores and online. H&M is finally showing signs of going in the right direction.
Firstly, that inventory pile is becoming more manageable. It was 18.3% of sales at the end of the second quarter, compared with 18.6% at the end of the first quarter. In fact, H&M said that the reduced need to discount to offload excess stock should add 1.5 percentage point to its gross margin in the third quarter.
Secondly, the changes that H&M is making, such as upgrading its namesake chain to be more like its Arket and & Other Stories outlets, appear to be chiming with customers.
The company said it expected local currency sales this month to be 12% higher than a year ago. That sent the shares up about 10%.
But there are challenges. Investors are at risk of getting ahead of themselves.
It must sustain the recent increase in demand. That may be possible if the current heatwave continues, but it is not guaranteed.
Analysts at RBC also point out that sales may be have been flattered by comparisons with the year-earlier period, when the company suffered from disruption as it implemented a new logistics system.
The company also faces risks from the foreign exchange environment, given that its current stock was purchased when the U.S. dollar was stronger. H&M is more at risk from the currency escalating than rival Inditex, because it sources more of its products from Asia.
And the competitive landscape is not getting any easier. Associated British Foods Plc’s Primark is continuing to expand across Europe and the U.S. and when it does so, it is opening ever more sophisticated stores.
H&M’s shares are up 25% so far this year, and trade on a forward price earnings multiple close to that of Inditex.
As I have argued, H&M is doing all the right things. Investment in its emerging brands is necessary to expand the top line, while the group is also now giving more attention to its core chain, which is squeezed between Primark at the low end, and Zara at the more premium level.
There is also always the possibility of a buyout lurking in the background, given that chairman Stefan Persson and his family own about half of the shares.
Sales growth must be sustained, and inventory shrunk substantially to demonstrate that H&M is finally out of the fashion wilderness.
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Andrea Felsted is a Bloomberg Opinion columnist covering the consumer and retail industries. She previously worked at the Financial Times.
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