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* Next has worst start to trading in 25 years
* Weaker pound, online shopping hurt traditional retailers
* Short-selling ticks higher in Debenhams, M&S
By Alasdair Pal
LONDON, Jan 4 (Reuters) - The worst start to a trading yearfor Next PLC shares since 1991 underscores the plight ofmid-tier UK retailers hit by a combination of fierce onlinecompetition and higher costs driven by a weaker pound.
Traditional British stores, particularly those relying onclothing, risk getting caught in no-man's land asbargain-hunting consumers find cheaper alternatives while therising popularity of online shopping, now nearly a fifth of UKretail sales, eats into their business.
Profit margins, already crimped by heavy discounting inefforts to maintain market share, now face additional headwindsas sterling weakness pushes up sourcing costs.
Next shares, down 18 percent in the first two trading daysof 2017, have fallen 41 percent in the past year. Debenhams and Marks & Spencer are down about a quarter andshort-selling, where funds borrow shares and sell them in thehope of buying back later at a lower price, has ticked higher inrecent months.
The troubles echo a trend seen across UK grocers wherediscount chains such Lidl and Aldi ate into the profits oflong-established chains such as Sainsbury, Tesco and Morrison.
While Next warned of tough times, B&M European Value Retail said it enjoyed record Christmas sales.
At the top end of the market, John Lewis, Britain's biggestdepartment store chain which also runs upmarket grocery brandWaitrose, saw sales in the week before Christmas soar 36percent.
"It mirrors what happened in the supermarket space," saidRichard Marwood, a fund manager at Royal London AssetManagement. "It was the people in the middle who struggled."
Marwood, who owns B&M shares, said that the company isenjoying the benefits of recent expansion but the jump inlike-for-like sales suggested it was attracting more consumerslooking for cheaper alternatives to traditional stores.
B&M, which sells products from toys to soft furnishings, isa top pick in the European retail sector for analysts atDeutsche Bank and Bank of America-Merrill Lynch.
Higher inflation and lower wage growth looks set to make2017 "the year of value" in UK retail, according to analysts atDeutsche Bank, which this week downgraded Next and Debenhams.
UK wage growth will fall below 1 percent in 2017, accordingto the OECD, while inflation in food and fuel is set to pick up- meaning consumers will have less to spend on discretionaryitems like clothing.
DOLLAR DILEMMA
Retailers buy a significant proportion of their goods inU.S. dollars from manufacturers in Asia, selling on to Britishconsumers in pounds.
"The fundamental issue is that you've seen a nearly 20percent trade-weighted depreciation of sterling over the courseof the last 12 months," said Jeremy Lawson, chief economist atStandard Life Investments.
A weaker pound is a direct hit to profits. And in an alreadytough environment retailers have little wiggle room on prices.
"They can hold the shop prices and hit margins, or they canput up prices but will have an impact on volume of sales,"RLAM's Marwood said.
Next is among those worst hit by currency moves, accordingto analysts at HSBC, as it pays in dollars for around 70 percentof its cost of goods sold.
Rivals like ASOS and Inditex, which sourcemore of what they sell closer to home, are poised to benefit andgrab market share by being even more competitive on prices,analysts at Bank of America-Merrill Lynch said in a note toclients.
VALUE BUY
Five hedge funds have significant short positions onDebenhams totalling 7 percent, an all-time high, according tolatest data from the UK's market regulator, the FinancialConduct Authority. On M&S, the ratio has more than doubled to2.2 percent over the last three months of 2016.
High levels of bearishness do leave stocks susceptible tobounces, however, if there is a rush of short-covering.
Also, with valuations already depressed, some investors arenot as downbeat on the sector.
Retailers "trade close to financial crisis multiples",suggesting sentiment may be too pessimistic on some companies,according to Tineke Frikkee, a fund manager at Smith &Williamson who owns shares in Debenhams and M&S.
For brave investors, bargain-hunting in shares ofbeaten-down retailers might just pay off.
In 1991, the last time shares of Next started the year witha double-digit decline, they ended up more than 250 percent.
(Additional reporting by Tricia Wright and Alistair Smout;Editing by Mark Trevelyan)
