The United States is by far the largest market for discount-warehouse-giant Costco Wholesale Corporation (NASDAQ:COST). However, the company is also focused on growing its business outside the U.S.
Canada is easily Costco's largest international market, accounting for 43% of its warehouses outside the U.S, and more than half of its sales outside the U.S. But Canada's importance to Costco goes beyond its size, because Costco's operations in Canada are extremely profitable relative to its operations in the U.S. or its other international markets.
Costco's best market
Last quarter, Costco produced operating income of $451 million on sales of $19.85 billion in the U.S., for a 2.27% operating margin. In its international operations outside of Canada, Costco earned $133 million on sales of $3.49 billion, translating to a 3.81% operating margin. Costco produced its highest segment operating margin of 4.71% in Canada, where it generated sales of $3.88 billion, and $183 million of operating income.
The superiority of the Canadian market stands out even more clearly when looking at Costco's return on assets: another key metric for investors. During its 2015 fiscal year, Costco posted a stellar 21.4% return on assets in Canada. By contrast, it earned a 9.9% return on assets in the United States, and an 8.5% return on assets in its other international markets.
This shows that, while Costco's other international markets also perform better than the U.S. from a margin perspective, Costco has had to make very large investments to earn those returns. Canada is unique in that it produces high margins without being overly capital intensive.
What makes Canada special?
There are two main reasons why Canada is such a profitable market for Costco, especially compared to the United States. First, Costco is the only warehouse club operating in Canada today, which allows it to earn a slightly higher gross margin there.
In the U.S., Costco faces competition from Wal-Mart (NYSE:WMT) subsidiary Sam's Club throughout the country, and from BJ's Wholesale Club along the East Coast. It also faces significant competition in some international markets, such as Mexico, where Wal-Mart's Mexican subsidiary operates 160 Sam's Club locations.
By contrast, Costco gained a huge first-mover advantage in Canada. Wal-Mart tried to elbow its way into the market a little more than a decade ago, opening six Sam's Club locations in the country. It was too little, too late. In 2009, Wal-Mart decided to shut down all six Sam's Club warehouses in Canada to focus on expanding its supercenter format instead.
Second, because Canada has a government-funded healthcare system, Costco has significantly lower costs there than in the U.S., where health-insurance costs are extremely high. As a result, Costco expects Canada to remain more profitable than the U.S. for the foreseeable future.
Can Costco create more Canadas?
Costco's biggest "problem" in Canada today is that it is a mature market. Costco is still growing at a steady pace there, but it already has more warehouses per capita in Canada than in any other market, including the U.S. This limits its expansion possibilities.
However, some of Costco's other international markets are actually more profitable than Canada. (Others aren't, which is why the "other international" segment, as a whole, has a lower operating margin than Canada.) Just like in Canada, Costco is the only discount-warehouse-club operator in many of these countries, and faces significantly lower healthcare costs there.
As Costco grows and matures its presence in these markets, it may be able to achieve enough of a first-mover advantage that competitors won't be able to challenge it. Most importantly, the more that Costco can expand in its highest-margin regions, the higher its company-wide margin can rise in the long run.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.