UPDATE 2-Gymboree shares tank 40 pct on bleak Q1 outlook

* Says product safety related changes to hurt margins

* Sees Q1 EPS $0.18-$0.25 vs estimate of $0.77

* Expects challenging retail environment to continue

* Sees inventory down to mid-to-high single digits by Q1 end

* Shares plunge as much as 40 pct in after-hours trading

(Recasts throughout, adds conference call comments, background, updates share movement)

By Mihir Dalal

BANGALORE, March 4 (Reuters) - Gymboree Corp (GYMB.O) forecast a bleak first quarter as regulatory changes related to product safety significantly weigh down on the children's clothing retailer, slamming its shares down 40 percent in aftermarket trading.

The company, which expects the challenging retail environment to continue throughout fiscal 2009, sees first-quarter earnings substantially below analysts' view.

Gymboree said regulatory changes related the Consumer Product Safety Improvement Act (CPSIA) passed by the Congress in August 2008 will impact sales and gross margins in the first half of 2009.

The Act required the Consumer Product Safety Commission (CPSC) to begin enforcement of new lead and phthalate standards for children's products on Feb. 10, 2009.

In order to comply with the new laws, the company began an initiative to remove any styles in its 800-plus stores that did not meet the new limits prior to Feb. 10, Chief Executive Matthew Mccauley said on a conference call with analysts.

The company had already pulled out products and changed production lines even before a clarification to the law was issued on Feb. 6, Mccauley said.

Separately, the company said a change in safety requirements related to levels of phthalates, a chemical used to increase flexibility in plastics, rendered about 1.7 million of its inventory obsolete.

"This...caused us to pull sleepwear for ages three and under off all of our shelves," said Mccauley.

The company, which operates Janie and Jack stores as well as its namesake Gymboree chain, however, reported a better-than-expected fourth-quarter profit, helped by higher sales and a lower tax rate.