Fast Fashion Isn't as Strong as It Looks: H&M Opened the Most Stores Last Year, and May Be the Most at Risk

Slowing economic growth, the drop in consumer demand that follows it, and a bubble in China's commercial real estate market all make H&M Group's next round of expansion risky.

In five years, its total number of stores worldwide grew from 2,776 to 4,351, the number of markets it operates in went from 48 to 64, and its workforce expanded from 72,000 to 114,000. In China alone, it added a net 91 stores in fiscal 2016 — a new store every four days.

The company behind that record is H&M Group, which runs 3,962 H&M-branded stores worldwide plus nearly 400 stores under brands including COS, &Other Stories and Cheap Monday.

Set H&M Group's expansion path against what is happening to other retailers, and it is easy to see it as the winner.

In China, the world's largest apparel market, once-dominant brands like Esprit and Etam are closing stores in waves; Meters/bonwe cut 1,500 stores in three years and in 2015 posted its first loss since going public. In the United States, the veteran apparel brand American Apparel filed for bankruptcy, while Abercrombie & Fitch and American Eagle have been closing stores, cutting staff and pulling out of markets...

But H&M Group's 2016 annual report, released in late January, tells people that things are not as good as they look.

Over the past year, H&M Group's sales grew 7%, but its gross margin fell from 59.5% in 2012 to 55.2%, and its operating margin dropped from 18.01% to 12.4% — both five-year lows.

What those numbers show is that new consumer demand is not enough to support expansion at this pace. The rising costs that come with expansion are now the most direct drag on margins. And to squeeze as much as it can out of each store while expanding so fast, H&M Group has leaned on frequent discounts to drive sales, which pulls margins down further.

Expansion itself is not a bad thing. A company grows by finding new markets and building out its operations, and expansion has genuinely helped H&M.

By concentrating store openings in the United States and China, it found growth outside Europe; by moving into South America and other regions, it cultivated markets ahead of its competitors. A wide sales network lets it reach more consumers, build its brand image and collect first-hand market data.

Expansion also shapes brand image. According to rankings by the market research firm Millward Brown, H&M is currently the third most valuable apparel brand, behind only Nike and Zara; Interbrand ranked it 20th by brand value in 2016, ahead of Adidas and Pepsi. The visibility of its physical stores helped.

But as the results show, expansion also carries risk, and investors are not optimistic. As of this writing, H&M's share price has fallen from a high of 363.8 kronor in early 2015 to 244.30 kronor.

"If this continues, H&M Group's profit will fall 40% by 2020 — that is basically simple arithmetic," Morgan Stanley analyst Geoff Ruddell said. He also believes that if nothing improves, profit will hit zero by 2022.

Those worries deserve more attention now that global growth is slowing and regional conflicts and political instability are spreading.

The International Monetary Fund cut its 2016 global growth forecast from 3.4% to 3.2% early last year; the actual figure came in at 2.7%, and it expects global growth of 2.9% in 2017. In China, GDP growth has slowed from close to 10% a few years ago to 6%.

According to University of Delaware lecturer Sheng Lu, citing Euromonitor data, China's apparel retail market will grow at a compound annual rate of just 6.3% between 2016 and 2020 — far below A.T. Kearney's 2013 forecast of 15% growth for women's apparel and 8% to 10% for men's apparel in China between 2012 and 2016. The compound annual growth rate of the US apparel market between 2016 and 2020 will shrink to 2.7%.

Against that, H&M Group still says it will "open stores aggressively in China and the United States" — a plan that runs straight against the trend.

Some optimists remain bullish on the fast-fashion business H&M belongs to. According to Quartz, citing Credit Suisse data, US fashion retailers' sales grew less than 2% over the past two years, while H&M and Zara grew between 8% and 10%. In China, Uniqlo did better still, with sales up more than 60% in 2014 and 40% in 2015.

But fast fashion does not wear permanent armor either. Just as American Eagle, Abercrombie & Fitch and American Apparel once did, it could fall out of favor with fickle consumers at any moment.

And when expansion turns toward emerging markets, fitting into the local retail and cultural environment has never been easy. Uniqlo's setback in the United States; Old Navy, a Gap brand, announcing in 2016 that it would close all 53 of its stores in Japan; Mango announcing in 2016 that it would close its shops inside 450 department stores, cutting its US store count to seven; even the online-only retailer Asos pulling out of China — all are warnings. Expanding under so much uncertainty adds to a brand's burden and can cost it the flexibility to adapt to local conditions.

But not expanding is impossible for H&M Group. Germany, its largest market, shows weak sales growth — it slowed to 3% in 2016 — while France, its fourth-largest market by contribution, saw sales fall 4% (both figures exclude currency effects).

"Germany is still H&M's biggest market right now, but I would not be surprised if China becomes the biggest soon," H&M Group global CEO Karl-Johan Persson said in a recent interview with CBNweekly. Call it confidence, or call it the growth H&M has to look for once its mature markets fill up.

Had he said that in 2013 or earlier, the problem would have been easier to handle. China's business environment has already changed. Besides the drop in consumer demand that comes with slower growth, the commercial real estate sector that once drove fast fashion's explosive growth is going soft.

In 2007, H&M opened its first mainland China store in one of Shanghai's established shopping districts. Over the following years its store openings tracked commercial real estate in tier-one and tier-two cities, moving into Joy City, MixC and Wanda Plaza malls around the country. Between 2012 and 2016, H&M Group's store count in China jumped from 134 to 444, and a key part of the strategy was to open with each newly launched mall and to follow property developers as they pushed down into tier-three and tier-four cities.

Fast fashion's relationship with commercial real estate is like the old relationship between apparel brands such as Esprit and Etam and the department stores: the first needs the second's channels, the second needs the first to bring in foot traffic, rent and a share of sales. If either side runs into trouble, the other can hardly stand on its own.

But after several years of aggressive building, China's commercial real estate has started to show regional bubbles. In 2013, investment in Chinese commercial property development reached 1.1945 trillion yuan, up 28.28% from the year before — and along with it came vacancy rates of 15% to 20% at malls in Chongqing, Shenyang, Qingdao and elsewhere. Development plans had run ahead of demand.

For now, fast fashion still looks like the tenant every new mall's leasing team wants, and luxury brands' eagerness to sit next door is more proof of how much traffic it pulls. But if the commercial real estate bubble bursts, chains like H&M will see their plan to follow developers down into tier-three and tier-four cities upended.

In 2016, investment in Chinese commercial property development came to 1.4607 trillion yuan, but growth was only 1.8%. A report from the RET China Commercial Real Estate Research Center says the supply of Chinese commercial property projects will peak between 2016 and 2017.

Zara, in fact, sensed the problem in Chinese commercial real estate as early as 2015. The world's largest fast-fashion chain announced then that it would slow store openings once it passed 500 stores in Greater China, because it had "moved into malls too eagerly in the early stage, and the next task will be opening flagship stores in key cities."

Zara had previously followed Wanda closely down into tier-two and tier-three cities. Now its strategy is "flagship stores in major cities," including larger single stores in upscale districts like Taikoo Li, and more effort spent on raising the return each store earns.

The return each store earns is exactly what H&M is giving up as it expands in China. Calculations from its financial reports show that H&M's average annual sales per store in China fell from about 40 million kronor (roughly 30.17 million yuan) in 2012 to 24 million kronor in 2016. Over the same period, average annual sales per store in Germany, H&M's largest market, passed 80 million kronor in 2016.

Take the CEO at his word that China will soon overtake Germany as the biggest market, and assume the deadline is five years (and that Germany stops growing over those five years): H&M China's sales would then have to keep a compound annual growth rate of at least 36%. In fiscal 2016, H&M China's sales grew 7%. Stretch the deadline to 10 years and growth would still have to stay above 14.6%.

E-commerce is treated as the other way out, and H&M Group knows it. Alongside its fiscal 2016 annual report, the company said it was replacing its target of "10% to 15% store expansion a year" with "10% to 15% growth in total sales a year." The difference is that the second target includes e-commerce. It applies to every market, but it matters most in China, which leads the world in mobile shopping.

"The past year has been marked by the whole industry shifting online at an unprecedented pace, and by digitalization," Karl-Johan Persson said at an analyst meeting.

According to iResearch, China's online shopping market was worth 3.8 trillion yuan in 2015, with apparel making up more than 20% of it; online penetration for apparel will eventually reach 37.6%.

But H&M China has no advantage in e-commerce. It only launched online sales in China in 2014, which was fairly late. Unlike Uniqlo, which moved onto Tmall from the start, H&M chose to build its own store, which meant giving up an important source of traffic — not necessarily a good trade for a brand in a hurry to expand. Zara also ran its own online store at first, but joined Tmall in October 2014, mainly because its China business had not met expectations and Tmall was clearly the more efficient route.

H&M explains the choice this way: "Tmall is like a bazaar for online shopping, a portal site. That model is common in the United States and Europe too. What matters to us is focusing on the way we offer shopping ourselves, how we stay in touch with customers, and giving customers what they want, even beyond what they expect," H&M Greater China general manager Magnus Olsson said in an interview with Southern Daily.

The strategy is understandable. Running its own store gives H&M more direct control over customer data, and that data offers clues about where to open stores, what each region wants and how to mix its products.

H&M Group says it is developing e-commerce and digital operations on three fronts: an omnichannel approach linking online and offline business (through tools like a mobile app and QR-code scanning), supply chain improvements (including next-day delivery in some markets), and more advanced data analysis. That last one really means reading and analyzing what its e-commerce data says.

Under its plans, H&M Group will introduce one or two new brands in fiscal 2017, though it has not said which cities they will enter. It has already opened 20 COS stores in China, which carry a different product mix and emphasize clean, spare displays and the in-store experience — another way to raise the return per store and get people talking. For now, though, H&M Group's bigger source of growth in China is still the H&M brand itself.

Tier-three, tier-four and tier-five cities are always seen as the place with huge room to grow. Right now H&M has 92 stores in Beijing, Shanghai, Guangzhou and Shenzhen, the four tier-one cities, one-fifth of its total in mainland China.

As noted above, the commercial real estate bubble is already here. Even without it, tier-three, tier-four and tier-five cities are a completely different consumer market from tier-one cities. Domestic brands including Meters/bonwe built their customer base by opening franchises everywhere, cutting prices, sponsoring variety shows and hiring celebrity endorsers — marketing methods international brands do not usually use.

But the change may already be underway. H&M has run a Chinese New Year collection for several years, and since 2015 it has signed Zhou Xun and Archie Kao, then Liu Wen and Choi Siwon, then Fan Bingbing and Li Chen as its faces for the line. For a brand that used to rely mostly on Western celebrities, it is hard not to read this as H&M testing how well celebrity marketing works in China — especially in tier-two, tier-three and tier-four cities.

One thing is close to certain: with the economy slowing, consumer demand weakening and commercial real estate in a bubble, growing as fast as before is clearly no longer easy.

Not just for H&M, but for every fast-fashion brand.

Cover image from H&M's official website