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, E-Commerce China Dangdang (NYSE: DANG).

Throwing the book at China
Dangdang was a hot IPO when it made its Wall Street debut three months ago. The fast-growing online retailer's offering was priced at $16 a share. It wasn't enough. It opened at $24.50, closing at a mind-boggling $29.91 on its first day of trading.

The stock is trading lower than its first-day close now, but that doesn't necessarily make it a bargain.

Dangdang finally reported its fourth-quarter results this morning. Revenue growth was strong, with sales climbing 59% to $107.7 million. Adjusted earnings, however, fell 25% to $2.6 million. Earnings per share on a GAAP basis came in at $0.03.

Analysts were expecting a profit of $0.02 a share on $106.6 million, so Dangdang did its part by landing ahead of the pros. The rub is that this isn't the kind of blowout performance that validates the stock's lofty valuation.

Dangdang relies largely on shipping low-priced books to make a living. It stocks a massive 620,000 book titles. Its average order is for a little more than $12. Dangdang is trying to expand into bigger-ticket wares, but media items still account for more than three-quarters of its business.

Margins, as you may imagine, are pretty meager. Net margins improved only marginally in the full 2010 year, and are still mired in the 1% to 2% range.

Investors that are used to ridiculously fat margins out of China's dot-com darlings are in for a rude awakening with its e-tailers. It's not just Dangdang. Apparel e-tailer Mecox Lane (Nasdaq: MCOX) posted results last week, and it too clocked in with net margins just shy of 2% for all 2010.

Historians may kindly point me to (Nasdaq: AMZN) circa the late 1990s. It was even posting losses -- as Dangdang did in 2007 and 2008 -- before cleaning up nicely. However, it's not fair to call Dangdang the of China. It's still too early. There are also plenty of competitors (including Amazon itself).

Dangdang closed out the quarter with 4.4 million active customers, 47% ahead of where it was during 2009's final period. Total orders rose by only 34%, but the 59% spike in revenue means that consumers are placing larger orders.

It is targeting revenue to grow by 50% to 52% in the current quarter, implying deceleration in its growth rate. I won't mark Dangdang down for that. Chinese companies have a refreshing way of underestimating their guidance, and we haven't seen enough of Dangdang on the quarterly earnings stage to know if it's low-balling reality.

This is simply a valuation call. Dangdang is a company to watch, but it's just not worth its $2 billion market cap until margins improve dramatically. Adjusted earnings may have nearly doubled to $6.2 million last year, but it has a long way to go before it grows into its chunky valuation.

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.

  • I wasn't impressed with Amazon's holiday quarter. Net sales climbed 36%, but earnings inched just 8% higher. The margin-crunching excuse here, at least, is that Amazon is sacrificing near-term results to outfit millions of bibliophiles with cheap Kindle e-readers. This is a strategy that will pay off nicely when Barnes & Noble (NYSE: BKS) follows Borders to the elephant graveyard of print publishing. Dangdang hasn't even crossed that obsolescence test. I should also point out that Amazon still came through with $2.5 billion in free cash flow last year, more than even Dangdang's lofty market cap.
  • Baidu (Nasdaq: BIDU): I can't recommend any of China's e-tailers. Mecox Lane is a busted IPO with decelerating growth. Dangdang may take a couple of years to justify its price tag. In this climate, I may as well go with the thicker margins generated by the country's undisputed search leader. Baidu is the paid search champ in China. Its latest quarter was spectacular. Revenue and earnings soared 94% and 171%, respectively. Baidu isn't cheap at 33 times next year's projected profitability, but this one is actually worth the premium.
  • Funtalk (Nasdaq: FTLK): It may take a few years before China's economy grows to the point where small-ticket e-tailers like Dangdang can make serious money on orders larger than its current $12.37 average. The fulfillment costs are just not right to strike a winning balance between consumers and merchants. Let's stick to the real world until then. Funtalk operates 718 retail outlets in more than 110 Chinese cities. It is growing quickly and trades at ridiculously cheap P/E multiples of 7 based on this fiscal year (which ends this month) and 6 looking at the year ahead.

I'm sorry, Dangdang. You're just one dang too many.  

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.