Luxury Brands Have a Strict Hierarchy. Burberry Found Out the Hard Way.

A seven-year push to woo richer consumers than the British brand normally caters to hasn’t worked. The appeal of taking a brand more upmarket is a better profit margin and, typically, stock-market valuation. If consumers think a label is exclusive, they will be more willing to pay a full price. This is why Louis Vuitton and Hermès RMS 0.18%increase; green up pointing triangle both have operating margins north of 40%. 

Since late 2017, Burberry has spent more than £700 million, roughly $911 million at today’s exchange rates, on investments to make the brand seem more high end, including expensive store refurbishments. But sales and operating profit at the end of Burberry’s last financial year were only 9% and 1% higher, respectively, than they were six years ago. By comparison, Louis Vuitton’s owner, LVMH MC -0.12%decrease; red down pointing triangle, has doubled revenue and almost tripled operating profit over the same time. 

Burberry’s products haven’t hit the mark with wealthier shoppers, while price increases have alienated its traditional customers. Last month, the company issued its second profit warning of 2024, scrapped its dividend and replaced its chief executive officer. 

New boss Joshua Schulman is an American who has done stints at U.S. brands Michael Kors and Coach. He has to decide whether Burberry should continue its uphill struggle or become a midprice luxury brand like his previous employers. 

Burberry would like to be a more luxurious brand, like Prada 1913 -0.92%decrease; red down pointing triangle or Louis Vuitton. If it is serious about the plan, HSBC analysts think earnings could be depressed for another three to five years. Investors’ patience is thin as the stock has underperformed other European luxury companies for a long time.  

One major obstacle to a successful makeover is that Burberry operates more like Coach or Michael Kors in the background. The company has become heavily reliant on discount outlets. Burberry has the highest dependence on factory stores of all European luxury brands, generating up to 30% of its sales in off-price and up to 60% of net profit, according to estimates from Bernstein luxury analyst Luca Solca. The average exposure for its European rivals is 5% of sales and 10% of profit. 

Outlets are lucrative as they can have similar foot traffic to flagship stores on expensive shopping streets like Fifth Avenue, but without the sky-high rents. This puts Burberry in a Catch-22. As long as it is selling roughly $1 billion of goods a year from off-price stores, it will be difficult to persuade customers to pay full price in its flagships. But closing outlets would send profits off a cliff.

If Burberry really wants to move upmarket, it needs to go cold turkey on outlets and take a painful hit to its bottom line. This would be easier as a private company, or within the portfolio of one of the major luxury-goods conglomerates such as LVMH or Kering.  

Another option would be to change course and follow the lead of Coach or Michael Kors, who run many of their flagship stores at a loss and make their profit from outlets. This would allow Burberry to cut costs, double down on its off-price business and boost profit. The trade-off would be a lower stock-market valuation than its European peers and an end to any hope of being a high-end luxury brand.

Burberry’s stock is already in the doldrums. After a greater-than-50% share price fall so far this year, the company’s enterprise value is equivalent to 6.6 times projected earnings before interest, taxes, depreciation and amortization, below the nine-to-12 times norm for a European luxury company. Unusually, the stock has been cheaper than both U.S. peers Tapestry and Capri CPRI -1.10%decrease; red down pointing triangle by this metric for all of 2024.

That might catch the eye of a bargain-hunting rival or a private-equity fund. A buyout firm that planned to turn Burberry into a British Coach could pay a 40% premium for the brand, increase net debt to five times Ebitda from 1.4 times in the company’s last financial year, and make an internal rate of return of more than 40% over five years, according to Bernstein calculations.  

Burberry’s attempt to join more rarefied circles hasn’t worked, so a fresh approach looks inevitable. That could be the best news its shareholders have heard in years. 

Write to Carol Ryan at carol.ryan@wsj.com