The house rules are simple in this weekly column.

  • I bash a stock that I think is heading lower.
  • I offset the sting by recommending three stocks as portfolio replacements.

Who gets tossed out this week? Come on down, Amazon.com (Nasdaq: AMZN).

It's the scene of the Prime
I've been a bull on the leading online retailer since the 1990s, scoffing at those who lost their shirts betting against Jeff Bezos.

  • Bears saw a company trading at a ridiculous earnings multiple. I saw a company trading at a more reasonable free cash flow multiple.
  • Cynics felt that bricks-and-mortar chains would get more aggressive in cyberspace. I backed a spunky e-tailer with seasoned fulfillment experience that was benefiting from a state sales tax pricing advantage.
  • Shorts felt that Amazon's growth was unsustainable. I witnessed the transformation of a debt-saddled company with anemic margins into a recession-proof juggernaut with chunky year-round profitability.

Last night's earnings report is problematic on many of those fronts. Forced into an e-reader price war, margins have come crashing hard at Amazon. Net sales climbed 36% to nearly $13 billion during the holiday quarter. That's good. Earnings climbed a mere 8% to $0.91 a share. That's better than analysts were expecting, but it's still bad.

The juicy free cash flow that bears paid the price in disregarding isn't what it used to be. Free cash flow slipped 14% during 2010 to $2.5 billion.

Cash-strapped states are now likely to follow New York in exploring ways to get Amazon.com and its smaller dot-com peers to begin collecting state sales tax.

Amazon's accelerating sales growth has also hit the brakes. Its 36% year-over-year top-line gain is slower than it was during the first three quarters of 2010. The midpoint of Amazon's sales guidance for the current quarter calls for continued deceleration. The worst part of Amazon's near-term outlook is that it expects a year-over-year dip in operating income for the quarter.

Bulls will argue that Amazon's now selling more Kindle e-books than paperbacks. I'll point to the emaciated margins and how troubling that makes Amazon's 12% gain in worldwide media sales. In other words, the e-book sales aren't helping the bottom line and they certainly aren't incremental.

Amazon's holding up better in consumer electronics and other non-media departments, but did you see Best Buy (NYSE: BBY) implode last month? Believers will suggest that Amazon is picking up Best Buy's business, but don't forget what happened to Best Buy bulls who figured that the superstore chain would be picking up Circuit City's business.

Amazon remains a class act, but its rich valuation given all of the margin crunches and future uncertainties makes it a tough darling stock to swallow at this point.

Good news
As I do every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave-ho. Let's go over the three fill-ins.

  • Wal-Mart (NYSE: WMT): Any leveling of the playing field between online merchants and their real-world competition is going to help Wal-Mart, which just happens to be no slouch in cyberspace. It's true that Wal-Mart's heady days of growth are in the past, but Sam Walton's discounting empire is priced at a mere 13 times forward earnings. Cheap chic discounter Target (NYSE: TGT) is slightly cheaper at 12 times forward profitability, but Wal-Mart has more Amazon-esque digital initiatives than Target. As the world's largest retailer, Wal-Mart also has economies of scale that no one else can match. The stock's 2.2% yield isn't much, but it sure beats current money market rates.
  • E-Commerce China Dangdang (Nasdaq: DANG): China's closest match to Amazon.com isn't a bargain. The company wasn't profitable until 2009. It's in the black now, but sporting net margins of 1% over the past two years isn't going to win over any valuation cynics. This is a work in progress. It remains largely a seller of cheap books in China. It's essentially where Amazon was in the late 1990s, with the hope-fueled financials to match. Why buy this overpriced online bookseller? Well, last month's IPO should help boost Dangdang's profile and its ability to expand into more lucrative bigger-ticket merchandise. Amazon's already in China via acquisition, but China has shown a preference for homegrown players.
  • Funtalk (Nasdaq: FTLK): I was going to go with Overstock.com (Nasdaq: OSTK) in this space. It doesn't have the e-reader margin killer that we find at Amazon, and the pros see the volatile e-tailer of closeouts continuing to grow at this point. However, it's hard to bank on Overstock or the analysts after the company has come up well short on the bottom line relative to Wall Street expectations in its two previous quarters. Let's go back to China then for an overseas play for those who are queasy over Dangdang's valuation. Funtalk is a cheaper ticket. The Beijing retailer of wireless phones and accessories had a network of 662 stores by the end of November. It's growing quickly. Analysts see revenue and earnings climbing 31% and 76%, respectively for its fiscal year ending in March. The stock is trading at a ridiculously cheap seven times this fiscal year's projected earnings.

Don't worry, Amazon. You certainly won't lose me as an active shopper. It's just your shares that I don't want in my checkout cart.

Please take our Motley Poll then scroll down to explain your vote in the comments section.

Best Buy and Wal-Mart Stores are Motley Fool Inside Value recommendations. Amazon.com and Best Buy are Motley Fool Stock Advisor choices. Wal-Mart Stores is a Motley Fool Global Gains recommendation. The Fool owns shares of Best Buy, and Wal-Mart Stores. 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.

Longtime Fool contributor Rick Munarriz doesn't mind taking out the garbage every so often. He does not own any of the stocks in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.