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Five Top Retail Stocks to Buy Ahead of Q4

Investors shouldn't expect too many surprises from retailers' fourth-quarter reports, but they should expect upside potential from these companies.

NEW YORK (

TheStreet

) -- Don't expect too many surprises from retailers' fourth-quarter earnings reports.

Indeed, even though the holiday season comprises a significant chunk of full-year sales results, fourth-quarter numbers hold little importance in the grand scheme of a recovery.

This, at least, is the contention of Wall Street Strategies analyst Brian Sozzi, who argues that what investors should be paying attention to are comments made by the managements of the retail companies about how 2010 is unfolding: How are booking trends? Are prices continuing to firm? What is the outlook for commodities in the second half of 2010?

And, of course, sequential sales improvements -- as Sozzi notes, investors ideally should want to see acceleration in growth rates from the first half of 2009 to the second half.

Still, since most companies cut costs dramatically in 2009, even modest top-line growth could provide earnings leverage, says Craig Johnson, president at Customer Growth Partners, a retail consulting firm.

Strongest of all, though, would be those retailers that are able to produce sales growth without giving up the margin gains from the past year, says Chandi Neubauer, analyst at Majestic Research. "In 2009, fundamentals meant nothing; these stocks were trading on sentiment," Neubauer says. "In 2010 we will see a move back to trading on fundamentals. If retailers don't

improve their top line, their stock will get hit."

Thus, steer clear of retailers who announce plans for new store openings in the United States in 2010 or even 2011, Sozzi argues, as more work still needs to be done in the domestic economy before companies can resume growth.

Likewise, when it comes to guidance, Sozzi says he wouldn't be surprised if only a few retailers laid their cards on the table for the full-year, or even the first-quarter, given the incremental weather that has plagued the United States since the beginning of the year. And those who do provide forecasts will most likely remain conservative, Citigroup analyst Deborah Weinswig wrote in a note.

Still, regardless of all these caveats, there remain a number of retailer stocks worth watching for their potential upside. Read on to see which ones they are -- and what to look for when they report.

Home Depot

It's no secret that

Home Depot

(HD) - Get Report

is an investor favorite in the home improvement sector heading into fourth-quarter earnings.

During the quarter, Home Depot's big-ticket sales began to rebound and its holiday and seasonal merchandise had a strong showing, Weinswig wrote.

But while apparel retailers bemoan the effects of weather on business, for home improvement retailers it is a legitimate concern, J.P. Morgan analyst Christopher Horvers wrote in a research note.

Luckily, for Home Depot, as far as temperature and precipitation trends are concerned, the company is benefiting from a great winter. "An incremental lift to comparable sales may be driven by the fact that the South and Southeast experienced much of the cold and snow," Horvers wrote. "With residents unaccustomed to such weather, we believe it brought solid sales of heaters, salt, shovels and even some snow blowers."

Regardless, the fourth quarter is an easy one for Home Depot in terms of sales comparisons. As a result, "investors are looking past the current quarter in anticipation of the potential for positive comparable sales in the spring selling season, which has a multitude of tailwinds that could drive revenue and earnings upside," Horvers wrote.

Indeed, ahead of its earnings report, which is scheduled for Feb. 23, Home Depot was upgraded by Oppenheimer on Wednesday to outperform from perform, while analysts expect the company to earn 16 cents a share on revenue of $14.06 billion.

"Home Depot is a name to own into earnings as we expect the company to provide a favorable 2010 outlook as the housing market improves and Home Depot realizes greater benefits from its merchandise and supply chain initiatives," Weinswig wrote.

Nordstrom

Nordstrom

(JWN) - Get Report

is the shining star of the luxury sector heading into fourth-quarter earnings. The high-end department store already reported same-store sales at the beginning of the month that were significantly higher than anticipated.

And since Nordstrom has a tendency to refrain from updating guidance in the middle of the quarter, Weinswig is confident that its earnings results will beat expectations.

Analysts are calling for earnings of 78 cents a share on revenue on $2.53 billion.

Nordstrom has seen success with its good, better, best pricing strategy and its beefed up juniors business. One of the only challenges remaining is its men's business, Johnson says.

Macy's

Macy's

(M) - Get Report

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could bring an element of surprise to the department store sector, as Weinswig says results may top company guidance.

Macy's upped its forecast after reporting a surprise increase in January same-store sales. The company now expects earnings between $1.35 and $1.37 a share. Weinswig predicts earnings could hit $1.38 a share.

The department store has seen strength with online sales, My Macy's localization initiative and its Bloomingdale's business. In fact Macy's is rolling out four Bloomingdale's outlets in 2010.

While Macy's is well-known for providing conservative guidance, Weinswig says investors may be presently surprised by its 2010 outlook.

American Eagle Outfitters

After more than a year of declining same-store sales,

American Eagle Outfitters

(AEO) - Get Report

saw its business begin to turn toward the end of 2009. In fact, it now has one of the strongest trends in the specialty retail segment, Sozzi says.

Analysts are forecasting fourth-quarter earnings of 33 cents a share on revenue of $962.2 million.

American Eagle's biggest advantage heading into spring are its plans to shorten lead times. This means it will be able to quickly replenish popular merchandise without worrying about over-ordering product that may not sell ahead of the season.

For the fourth-quarter investors will be waiting to see if management provides any update on the future of contemporary chain Martin + Osa, which has been a drag on earnings.

But Neubauer doesn't think management will provide a direct answer as to whether or not they will shutter the division.

Aeropostale

No matter what Aeropostale does, it just keeps getting a beatdown from Wall Street.

Still, the teen retailer has reported 14 consecutive quarters of earnings growth, and the fourth quarter isn't expected to be an exception. Analysts are calling for earnings of $1.42 a share on revenue of $791.8 million.

Consumers, thus, are still focused on Aeropostale's value-message, which won't change in 2010, Sozzi says. The company also has significant opportunity with its newest children's concept P.S., which targets an underserved segment in the market.

Nonetheless, analysts don't foresee much upside to the stock. The reason: investors are more focused on turnaround stories -- like

Gap

(GPS) - Get Report

or

Abercrombie & Fitch

(ANF) - Get Report

-- than solid, steady companies, Chandi says.

--Reported by Jeanine Poggi in New York.

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