* Many retailer margins already seen declining
* Urban Outfitters, Dillards among those hit
* Free shipping, longer hours add to expenses
By Brad Dorfman and Jessica Wohl
Dec 14 (Reuters) - Best Buy Co Inc (BBY.N) is the first of many retailers that will report falling margins as merchants reluctantly cling to steep discounts to draw U.S. consumers in this holiday season.
On Tuesday, electronics retailer Best Buy saw its shares fall more than 15 percent when third-quarter earnings missed analyst expectations because of discounting. [ID:nL1E7ND1JM]
Best Buy is the first major retailer to report earnings for a period that includes "Black Friday," the day after Thanksgiving that marks the start of the brisk U.S. holiday shopping season. As more retailers report, more disappointing margins are expected.
"I think Best Buy is the canary in the coal mine. I think we're going to hear retailers across all categories, with the exception of luxury, reporting depressed margin for the holiday time period," said Joel Bines, managing director of consulting firm AlixPartners.
Over the past several days other retailers, including industry giant Wal-Mart Stores Inc (WMT.N), have said that they will see margins hit by discounting as consumers faced with high unemployment and economic uncertainty have been conditioned to search for deals.
"We are investing in price," Walmart U.S. Chief Merchandising Officer Duncan Mac Naughton said last week at a Credit Suisse conference. "You've seen that in our Q3 margin; we had a 22 basis-point compression in margin. You're going to see it again in Q4, because we continue to invest in price to drive our price separation and our price leadership."
Wal-Mart's gross margin is expected to fall to 24.5 percent this quarter from 25.1 percent a year earlier, according to data compiled by Thomson Reuters I/B/E/S.
Other retailers where analysts expect to see declines are: Gap Inc (GPS.N), to 32.7 percent from 38.2 percent; J.C. Penney Co Inc (JCP.N), to 36.7 percent from 37.6 percent; Macy's Inc (M.N), to 41 percent from 41.3 percent; and Abercrombie & Fitch Co (ANF.N), to 60.1 percent from 63.6 percent.
Retailers were expected to have to discount heavily to snatch customers from competitors this season, as total sales were not expected to grow that much, despite the flurry of crowds that came out on Black Friday.
With higher cotton prices from the first half of the year still filtering through the supply chain, the question is which retailers will be hit worse than expected.
On Monday, clothing retailer Urban Outfitters Inc (URBN.O) said that same-store sales were up mid-single-digits so far in the fourth quarter and its shares jumped.
But Barclays analyst Stacy Pak said the cost of promotions was likely greater than expected and lowered the fourth-quarter earnings estimate for the retailer to 36 cents a share from 38 cents a share.
After a meeting with management, J.P. Morgan analyst Matthew Boss said he expected gross margins for department store chain Dillards Inc (DDS.N) to be worse than expected, citing a more promotional competitive environment, especially in goods where the same product is also sold at rivals like Macy's and J.C. Penney.
Offers like free shipping for online sales raise costs for retailers, who hope to make it up by selling more stuff.
Target Corp (TGT.N) and Walmart are among the other chains that started to offer free shipping on their sites this season, with certain conditions.
"Almost everybody is on the free shipping kick," Trutina Financial Chief Investment Officer Patty Edwards said.
Labor costs are also likely to hit margins, as retailers extend hours to try to get shoppers in, Edwards said.
Macy's will be open for 83 straight hours beginning Dec. 21 and Sears Holdings Corp (SHLD.O) said its Sears stores will stay open until midnight from Dec. 14 to Dec. 23.
The National Retail Federation forecast a 2.8 percent increase in sales for November and December, compared with a 5.2 percent rise in the 2010 holiday season. However, the trade association said on Tuesday that it would re-evaluate that forecast based on the strength it has seen so far. [ID:nN1E7BC0CH]
As Christmas draws closer, more deep discounts are in the offing.
"Consumers are really waiting for another spate of deals as strong as Black Friday and Cyber Monday to really get them off their couches," said John Long, retail strategist for Kurt Salmon. "As we get further and further into the holiday season, that's what consumers are still responding best to."
(Reporting by Brad Dorfman and Jessica Wohl in Chicago; Additional reporting by Phil Wahba in New York, editing by Matthew Lewis)
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