UPDATE 4-H&M falls short as cotton, price cuts hit margins

* Q4 pretax 7.18 bln SEK vs consensus f'cast 8.17 bln

* Gross margin 63.2 pct vs f'cast 63.7 bln

* Says cotton prices doubled in 2010

* Shares dive 6.9 pct to six-month low

(Adds CEO comment, updates share price)

By Anna Ringstrom and Rebecka Roos

STOCKHOLM, Jan 27 (Reuters) - World No.3 fashion retailer Hennes & Mauritz (HMb.ST) warned a squeeze between rising raw materials costs, and in-store markdowns to stay competitive, was set to tighten as it posted a surprise fall in profit.

The budget chain's shares dropped to a six-month low as it revealed further price cuts this quarter in the battle for market share, and remained tight-lipped on pricing thereafter.

"Cotton prices will have a bigger negative effect in the first and second quarter," Chief Executive Karl-Johan Persson told Reuters.

Persson also expected an adverse dollar exchange rate to have an effect in the first half.

He was upbeat on 2011, even though some governments may slash budgets, which could dent consumer confidence. Retailers are worrying whether they can pass on rising costs to customers.

"Many experts say 2011 will continue to be good, despite austerity measures. So, overall, I am pretty optimistic when it comes to the global economy and I believe we will grow market share and sales in comparable units."

The weak fourth-quarter results revealed on Thursday add to concerns that rising prices of raw materials such as cotton CTH1 -- which hit record highs this week on supply concerns -- will especially harm budget clothing chains. [ID:nLDE70N13Z]

Pretax profit at H&M fell to 7.18 billion crowns ($1.1 billion) from 7.99 billion in its fourth quarter, against a consensus 8.17 billion forecast in a Reuters poll.

Gross margin shrank to 63.2 percent from 66.3 percent against a forecast 63.7 percent.[ID:nLDE70J239]

H&M shares plunged 6.9 percent to 212.90 crowns by 1253 GMT.

British discount fashion chain Primark, part of AB Foods, (ABF.L) warned last week that soaring cotton prices would hit margins, while mid-market rivals such as Next (NXT.L) are hiking prices to offset higher costs. [ID:nLDE70I1DV] [ID:nLDE70409D]

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For a related analysis, double click on: [ID:nLDE70N10P] Graphic on clothing retailers: r.reuters.com/gar67r Graphic on cotton price surge: r.reuters.com/ret24r Euro zone retail sales: r.reuters.com/nud32r ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

LACKLUSTRE

"The factors affecting (the quarter) were less spare capacity at suppliers, higher transportation costs and significantly higher raw material prices," H&M said, noting cotton had almost doubled in price in 2010.

"Increased investment in the customer offering, to strengthen market position, also had a negative effect on the gross margin," it said, adding markdowns were at the same level as a year earlier.

H&M announced markdowns in the first quarter this year in line with a year ago, indicating further margin squeeze.

SG Securities analyst Anne Critchlow said: "It does beg the question what the gross margin is going to be like next year (fiscal 2010-11). The answer is worse than consensus."

"Current trading looks fairly lacklustre," Critchlow added, noting sales data for December and January looked fairly weak against a reviving economy in Germany, H&M's biggest market.

H&M shares have outshone the STOXX Europe 600 retail index .SXRP over the past year, but this outperformance has declined in recent months amid fears over margins. [ID:nLDE70N0Q7]

It aims to open some 250 stores net in 2010/11. In September it cut 2009/10 expansion plans to 220 stores from 240, due to a halt on construction of shopping malls in southern Europe.

H&M said sales in December, the first month of its fiscal year, rose 8 percent in local currencies, but were unchanged on a like-for-like basis. Sales rose 9 percent from Jan. 1-25.

It is paying a dividend of 9.50 crowns per share for 2010, above a forecast 9.35.

($1=6.447 Swedish Crown)

(Additional reporting by Mark Potter; Editing by David Holmes and David Hulmes)