STOCKHOLM | Thu Sep 29, 2011 - Hennes & Mauritz suffered a 15 percent drop in third-quarter profit as the world's No. 2 fashion retailer was hit by a spike in cotton prices and other input costs, compounded by negative currency moves.

Campaña de otoño de H&M

The drop was smaller than expected, however, as the Swedish group's strategy to absorb the higher costs helped it to win market share, and H&M's shares jumped over 4 percent in early trading on Thursday.

The budget retailer also showed its confidence by increasing its target of store openings for this year to 265 from 250.

"This was going to be the most challenging quarter, so I think they've done a good job," said SG Securities analyst Anne Critchlow.

"Even better, they found their extra space in high-growth markets such as China and Croatia," she added.

At 0840 GMT, H&M shares were up 4.1 percent at 203.8 Swedish crowns, outperforming a 0.7 percent rise in the STOXX Europe 600 retail index .SXRP.

Europe's retailers are grappling with a slowdown in spending as shoppers cut back amid rising prices, subdued wages growth and austerity measures. A sovereign debt crisis in the euro zone is also weighing on confidence.

Inditex (ITX.MC), the world's biggest fashion retailer, said last week its sales growth had slowed since the end of July.

H&M said inventories were running higher than expected at the end of the third quarter and September sales were held back by warm weather, raising fears among some analysts it might have to discount heavily in the months ahead.

"There is a clear risk that 4Q markdown will be higher than expected," Liberum analysts said.

Chief Executive Karl-Johan Persson told Reuters the sales were also hit by the weak consumer confidence in Europe.

"It's difficult to see what is what," Persson said. "September, I think, is most related to weather. Then there are also some economic concerns behind, too."

Sales were up 3 percent in local currencies from September 1-27 and analysts said that equated to a decline of 5-6 percent in same-store sales, following a flat performance in August.

Persson said the outlook on costs and currency moves was brighter, though the effect from cotton prices would still be negative in the fourth quarter.

EARNINGS OUTLOOK

H&M, with more than 2,300 stores in 41 countries, made a pretax profit of 4.85 billion crowns ($716 million) from June through August, against a mean forecast in a Reuters poll for 4.66 billion, and a year-earlier 5.74 billion.

The gross margin shrank to 58.6 percent from 60.5 percent, overshooting a forecast for 58.1 percent. Markdowns in the quarter were at the same level as a year ago. Analysts had feared they would be bigger due to inventory levels at the end of the previous quarter.

"If we don't get much colder weather, we'll see some discounts and markdowns in the fourth quarter. But we also see that cost pressure will decrease in the fourth quarter, due to lower cotton prices and currency effects," said Sydbank analyst Nicolaj Jeppesen.

Shares in H&M, which sells about 85 percent of its floppy hats, high-waisted trousers and polonecks in Europe, have lost around a quarter of their value since last year's record high, when concerns first arose about its profit outlook.

But the stock -- like that of "cheap chic" rival Inditex -- trades at a much higher multiple of forecast earnings than those of rival clothing retailers like Gap (GPS.N) and Next (NXT.L), due in part to historically stronger profit growth.

Liberum analysts were concerned the premium is too high.

"Without GM (gross margin) gains or meaningful LFL (like-for-like growth), this is a business growing at nearer 10 percent than 20 percent," they said.

H&M also said it was delaying the launch of its U.S. online business to autumn 2012 from spring next year in order "to ensure the best possible reception at the launch."

Inditex's flagship Zara brand recently went online in the United States.

($1 = 6.775 Swedish Crowns)

(Additional reporting by Mark Potter in London; Editing by Hans-Juergen Peters)