Successful companies need an economic moat. The term economic moat, coined by the fabled investor Warren Buffett, refers to the ability of a business to maintain competitive advantages in order to protect its long term profits and market share from competing firms. The term implies the presence of factors that allow a company to be able to match the product quality offered by its competitors, but at the same time outperform those competitors in profits. For firms in the luxury goods industry, this usually means a brand image that creates an aura of exclusivity. The flip side to the presence of such a brand image, however, usually means lower sales numbers per quarter. Therefore, each firm in the luxury goods market has to evaluate for itself the trade-off involved between activities that boost its sales and activities that protect its exclusive appeal to customers.
The Coach (NYSE:COH) brand is an affordable mid range designer handbag brand. It offers luxury products at price points where the European luxury players cannot compete effectively. At the same time, its handbags come with a quality and price tags that put them in the category of luxury for most consumers. Despite these factors, Coach has seen its market share fall from 19% to 17.5% between 2011 and 2012. Much of this share has been grabbed by competitors such as Michael Kors, Kate Spade and Tory Burch. Comparable store sales have also fallen for three consecutive quarters. Our analysis below evaluates why this might be so.
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Competition Imitates Competition
In a profitable industry, over time competition will erode any competitive advantages enjoyed by a firm. Once a firm establishes competitive advantages, its superior operations generate boosted profits for itself, thus providing a strong incentive for competing firms to duplicate the methods of the leading firm or find alternate better operating methods. Coach’s main competitor in the U.S. handbags and accessories market, Michael Kors, has done just that. Since going public in 2011, Michael Kors has operated in malls and street locations, sold accessories-heavy collections and priced its products in the “accessible” luxury spectrum – all three strategies that Coach had employed to propel itself into the market leader position in the market space over the previous decade.  Moreover, Kors’ marketing strategies have been more effective in managing to appeal to the consumer base. Coach, on the other hand, has not been able to effectively transition its strategies from targeting its aging demographic to the younger consumers.
Factory Channel Too Dominant
A data point of great interest regarding Coach is that it derives two-thirds of its North American sales from factory outlets. That figure represents nearly 50% of total sales, a percentage that is too high for a true luxury company. The most important difference between an outlet store and a retail store is that the former usually does not sell the newest products made by that brand. The products sold at outlet stores are generally left over items from the previous years’ stock. Usually, these products are sold at a heavy discount, and sometimes there are also sales that are offered on top of the discounts. Some outlet stores, like those that sell clothing and fashion accessories, may sell products that are of a slightly lower quality than those offered at a retail store. Taking these factors into account it is easy to draw some conclusions about Coach:
- A significant percentage of Coach’s North American sales is being derived from lower priced sales at factory outlets. If this trend continues, we can expect profit margins for Coach to drop further.
- The easy availability of Coach hand bags is no doubt affecting its brand image. If everyone can have a Coach hand bag, its appeal as a luxury product is suspect.
- Given the easy availability of information on the Internet, and the pre-shopping opportunities of selection that it provides, it is possible that customers who want to buy Coach’s products are foregoing shopping in its retail stores and waiting for the same products to come up at its factory outlets, at lower prices. This might be the factor that is causing same store sales for Coach to go down. 
- The frequency with which Coach offers discounts and coupon deals might be boosting sales numbers per quarter, but at the same time affecting the company’s brand image. A cursory glance at the Twitter pages of Coach  and its competitor Michael Kors  reveals that discounts are far more common for Coach’s products than its competitors in the accessible luxury goods space.
According to the Luxury Goods Worldwide Market Study Fall 2013 by Bain & Company, the U.S. overtook China as the leader in consumer spending on luxury goods in the year 2013. However, one of the biggest factors driving consumer spending in this market was spending by the increasing number of Chinese toursits visiting U.S. cities such as Las Vegas and Los Angeles. Additionally, one might recall that one of the silver linings for Coach in its last quarter’s earnings was the 25% growth in sales in China. On the face of it, one might take these two points to mean that sales in the U.S. might recover on the back of Coach’s growing popularity with Chinese consumers. However, it is also possible that Coach’s eroding brand image as a leading luxury brand might turn the same customers away from the brand and this can impact the company’s sales numbers in China as well. 
Our $59.50 price estimate for Coach’s stock which stands at a ~25% upside to the market price.Notes: