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"I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty." -- Warren Buffett, 1987

Almost a month ago, I wrote an article detailing when the appropriate time to initiate a new position in Philip Morris (NYSE:PM) would be. The required event has since occurred, and we increased our position when the share price was at $88. Since then, the stock has reached $93 for a return of almost 6%.

Today, we decided to take the time to elaborate in more detail exactly why we believe this company to be a long-term holding for any portfolio. We will delve into the company's financial statements in the Buffett-esque manner described in Mary Buffett's introductory book Warren Buffett and the Interpretation of Financial Statements.

First, there is the nature of the product sold; tobacco products have undergone very little change through time compared to companies in the technology sector that deal with computer hardware, such as Apple (NASDAQ:AAPL) or Intel (NASDAQ:INTC). The cost of diversification into alternative nicotine delivery systems such as electric cigarettes, snuss, or other methods is far lower than research into alternative and increasingly small semiconductor systems.

According to Buffett, a company that has a durable competitive advantage will exhibit a gross profit margin of 60% or more. Favorite Buffett stocks such as KO and MCO have margins of 60 and 73%, respectively. From 2009 to 2011, PM's gross profit margin increased from 64.0 % to 65.7%.

Second, when we are looking at the selling, general, and administrative expenses, we see that PM has actually decreased its SGA Expenses 7%, declining from 36.8% to 34.2% of gross profit from 2009 to 2011. We also see on the annual income statement zero R&D expenses. Compare this with Intel, a company that needs to create new products or the old ones become obsolete, that in 2011 spent 22% of its gross profit on SGA expenses, but an additional 25% on R&D for a total of 47% of its gross profit being eaten up by these expenses.

Beyond increasing after-tax profit by 14% and 18% from 2009-10 and 2010-11, respectively, the profit as a percentage of total revenue has increased from 10.2% in 2009 to 11.2% in 2011. Buffett states that above 20% is ideal and that this is seen for companies such as KO (for 2011 at 18%); however, when we compare it with competitor British American Tobacco (NYSEMKT:BTI), which is at 20% in 2011, BTI may have a competitive advantage over PM. This is also apparent when the earnings per share for both companies are compared over the last five years. BTI increased earnings per share from 1.23 to 1.36, whereas PM decreased from 3.33 to 3.25 from 2008 to 2009.

Now let's shift our discussion to the debt of the company. The assets/liabilities ratio for PM has decreased from 1.20 to 1.01 between 2009 and 2011 with an increase in long-term debt. Contrast this with BTI, which increased its assets/liabilities ratio from 1.40 to 1.43 between 2009 and 2011 while decreasing its long-term debt. PM possesses more debt than BTI; however, Buffett says long-term debt is only a problem if the company does not have enough annual net earnings to pay off long-term debt within three or four years. Despite PM being at its lowest assets/liabilities ratio in company history, it would still be possible to pay off all long-term debt in 2010 or 2011 in less than two years. Interestingly, in 2009, it would have taken PM slightly over two years to pay off all long-term debt, indicating that while PM has high debt levels currently, the cash flow it possesses are more than adequate to pay it off in a reasonable time frame. BTI would also take over two years to pay off its 2011 long-term debt, which is down from the over three-and-a-half years in 2009.

In terms of retained earnings, PM's have been growing at an increasing rate every year since the creation of the company. When this is compared with BTI in the following table, the competitive advantage of PM can be seen easily; it simply produces more cash, more reproducibly than BTI, allowing for far more stock buybacks than BTI.

Click to enlarge image.

PM and BTI retained earnings

Investors will, of course, need to do their own research before initiating a position in any stock. However, we believe that based on the above criteria for a stock to buy and hold for the long run, PM is one such stock. Headwinds we see are that should an interest rate increase occur, PM will have more expensive debt and, of course, continuing eurozone problems. BTI is also a viable investment in our opinion, but for the present time we believe all the data points to PM outperforming BTI in the near future.

Disclaimer: If you buy the Mary Buffett book from Amazon.com after clicking the above link, I receive a small commission. If you wish to purchase it without this occurring, just search for the book on Amazon.com.

Source: The Long-Term Durable Competitive Advantage Of Philip Morris