* Profit down by a fifth in three months through August
* CEO says sales have fallen short of targets
* H&M plans 385 new stores this year, down from 400 (Adds company, analyst comment, updates shares)
STOCKHOLM, Sept 28 (Reuters) - H&M is falling short of its sales targets, the boss of the world's second largest fashion retailer warned on Thursday, after hefty summer discounts reduced quarterly profit by 20 percent.
H&M faces rising competition in its core European budget fashion market including from young shoppers defecting to online retailers such as Asos and Zalando.
"The fashion retail sector is growing and is in a period of extensive and rapid change as a result of ongoing digitalisation," CEO Karl-Johan Persson said in a statement.
"Our growing online sales did not fully compensate for reduced footfall to stores in several of our established markets, which has resulted in our total sales development not reaching our targets so far this year."
It will trim its target for net store openings this year to 385 from around 400, it added, having added 418 in the 12 months to the end of August for a total of 4,553 worldwide.
H&M offered deeper summer discounts to clear inventory this year, squeezing its gross margin to 51.4 percent from 54 percent a year earlier, yet levels of leftover garments still grew in the quarter to the end of August.
Shares in the second-biggest apparel retailer after Zara owner Inditex were down 5.6 percent at 1345 GMT.
H&M is looking for long-term growth by branching out into new and higher-end brands, with ARKET the most recent addition, although 9 out of 10 stores are H&M-branded. It has also started investing in tech startups in search of fresh ideas.
NEW ONLINE OPTIONS
In the short term, analysts say it is key that H&M speed up the integration of stores and online, and improve its delivery services, something that is costly for a low-margin brand.
"What should H&M do? Invest faster and more heavily in online service, which could hurt the margin? Or go more slowly, and risk damaging sales?," said Societe Generale analyst Anne Critchlow, who has a "sell" recommendation on H&M's shares.
"H&M has innovative and ambitious management, but there are challenging times ahead for value fashion retailers."
The company is testing click-and-collect in Britain, and rolling out faster delivery options, online returns in stores and mobile payments in some markets.
It said that after a good start, sales in September slowed somewhat towards the end of the month.
H&M also said it had shortened lead times on many products which, together with more in-season purchases, would help lower inventory levels in future.
"We expect some short term sales disruption from the need to clear excess inventory, (but) we expect sales and gross margin trends to improve next year due to online improvements and a firmer recent euro trend versus the U.S. dollar," said RBC analyst Richard Chamberlain, who holds an "outperform" rating on the stock.
H&M reported a pretax profit for the three months to August 31 of 5.02 billion Swedish crowns ($614 million), in line with forecasts by analysts in a Reuters poll. ($1 = 8.1689 Swedish crowns) (Additional reporting by Helena Soderpalm; editing by Keith Weir and Jason Neely)