Tesco says recovery plan working after profit collapse

* Tesco (Xetra: 852647 - news) says underlying UK sales on improving trend

* Volume of goods sold and transactions up in UK

* First (Other OTC: FSTC - news) half profit slumps year-on-year

* Firm to retain Dunnhumby, says no more disposals (Adds CEO, analyst comment, updates shares)

By James Davey and Kate Holton

LONDON, Oct (HKSE: 3366-OL.HK - news) 7 (Reuters) - Britain's biggest retailer Tesco said it was trading ahead of expectations and outperforming rivals after a move to sacrifice short term profits in favour of investment in lower prices and better service won back customers.

Reporting first half results a week after rival Sainsbury (Amsterdam: SJ6.AS - news) 's showed it too was getting to grips with the turmoil in the supermarket sector, Tesco showed a sustained improvement in underlying sales in its key home market, enabling it to reiterate full-year profit guidance.

The cost, however, of rebuilding a business and a brand that was on its knees this time last year was high.

Tesco's first half profit slumped 55 percent to 354 million pounds ($541 million) and CEO Dave Lewis said on Wednesday he would invest more in the second half to further regain competitiveness.

Shares (Berlin: DI6.BE - news) in the group, down 20 percent over the last six months, traded 2.7 percent higher at 1426 GMT.

"Lewis has successfully corrected the direction of travel," said Kantar Retail analyst Bryan Roberts.

After two decades of growth, Tesco dramatically lost its way, distracted by expensive overseas expansion when it should have been responding to the rise of discount grocers Aldi and Lidl at home.

It (Other OTC: ITGL - news) reported an annual loss of 6.4 billion pounds ($9.8 billion) in April (LSE: 0N69.L - news) , one of the biggest in British corporate history, and also manipulated its accounts last year, prompting investigation by Britain's Serious Fraud Office.

"Every important part of Tesco has been, or is being, transformed -- operationally, culturally or financially...and it is working," said Lewis, a former Unilever (NYSE: UL - news) executive who joined Tesco in September last year to turn the business around.

VIRTUOUS CIRCLE

Against Tesco's six major benchmarks of profit, sales, cash, customer loyalty, staff and supplier satisfaction, it was either on or ahead of target at both a group and UK level, Lewis told reporters.

"Critically the virtuous circle is beginning to work again as volumes grow," he said, noting UK customer numbers were up by about 150,000 year-on-year.

Volumes, the amount of goods sold, were up 1.4 percent in UK stores, while transactions rose 1.5 percent.

Lower prices meant however that sales in UK stores open over a year still fell, albeit at a slower rate. They were down 1 percent in the second quarter, an improvement from the 1.5 percent decline recorded in the first quarter.

That was at the top end of analyst expectations of a fall of between 1 to 1.5 percent and better than Sainsbury's, Asda and Morrisons' most recent quarterly performances.

Lewis said a typical basket of Tesco shopping was 3 percent cheaper year-on-year. He expects more deflation in the second half. "We don't see the market condition changing," he said.

International sales, which account for more than a fifth of the group total, showed their first like-for-like increase in nearly three years in the first half, boosted by recovery in Poland and Slovakia.

One major Tesco institutional shareholder welcomed the results.

"The stand out for me was the comment on volume and transaction growth," he said, speaking on condition of anonymity. "That suggests that something is improving on an underlying basis."

NO MORE DISPOSALS

Concerns linger around the strength of Tesco's balance sheet and when it can rid itself of a junk credit rating.

Lewis said no further material disposals were planned following the recent sale of its South Korean unit for $6.1 billion, which cut total indebtedness to 17.7 pounds.

Tesco will now retain its Dunnhumby data unit after a planned sale flopped.

Further debt reduction would come from better cash generation from retained businesses, while seeking cash from shareholders was not being considered.

Though finance chief Alan Stewart said Tesco was not under any debt or liquidity pressure, given 5 billion pounds of undrawn facilities, some analysts remain unconvinced.

"We continue to believe that Tesco will need to raise capital and potentially a considerable amount in order to progress without looking over its 'balance sheet shoulder'," said Shore Capital analyst Clive Black. ($1 = 0.6538 pounds)

(Additional reporting by Paul Sandle and Emma Thomasson; Editing by Keith Weir)