Tesco dampens profit growth expectations as price war rages

* First (Other OTC: FSTC - news) quarterly rise in underlying UK sales for 3 years

* Says market "challenging, deflationary and uncertain"

* Says further investment required

* Shares (Berlin: DI6.BE - news) fall up to 7.7 pct (Adds further CEO comments, analyst comment, updates shares)

By James Davey and Paul Sandle

LONDON, April 13 (Reuters) - Tesco (Xetra: 852647 - news) , Britain's biggest retailer, warned a supermarket price war meant profit growth would be hard to deliver this year despite a sales recovery picking up pace.

Hammered by changing shopping habits, the rise of German discounters Aldi and Lidl, and an accounting scandal, Tesco reported a first rise in underlying annual profit in four years and its first quarter of underlying UK sales growth for over three years. But it said there was much more work to do.

Shares in Tesco, which controls 28 percent of Britain's grocery market, had risen 31 percent so far this year on recovery hopes but fell as much as 7.7 percent on Wednesday.

"We feel like we stabilised the business. We don't feel that we're in the crisis that, being candid, we were 16 months ago," Chief Executive Dave Lewis told reporters.

"More customers are buying more things more often at Tesco," he said, highlighting fourth quarter UK volume growth of 3.3 percent and a 2.8 percent rise in customer transactions.

But Lewis warned investors that Tesco's recovery would be a bumpy ride as it cuts more prices and invests in the quality of its products to help protect its leading position in Britain.

"Do we have a plan to improve the profitability of the business year-on-year? Yes we do," said Lewis.

"Will it be a straight line from the second half of this year? We don't see it that way, given the market that we read."

The need to invest in this "challenging, deflationary and uncertain market" would impact the pace of profit growth in the 2016-17 financial year, particularly in the first half.

Prior to Wednesday's update, analysts' consensus forecast for operating profit before one-off items in 2016-17 was 1.25 billion pounds ($1.78 billion).

"If we were to achieve that and make all the investments we want to make, that is a significant achievement," said Lewis.

Analysts said forecasts were likely to be downgraded.

Haitong Research analyst Rickin Thakrar anticipated a reduction in 2016-17 earnings per share consensus of over 10 percent, as Tesco further invests to fend off sharper prices at rival Asda.

BROAD BASED IMPROVEMENT

Tesco made underlying operating profit of 944 million pounds in 2015-16, ahead of analysts' expectations of 932 million pounds and the 940 million pounds it reported in 2014-15.

The outcome is a far cry from the trading profit of 3.97 billion pounds that Tesco generated in 2011-12 before its strategy unravelled under Lewis's predecessor Phil Clarke.

Tesco has not paid a dividend since the first half of its 2014-15 year. Finance chief Alan Stewart said there was no pressure from investors to set out a timetable for its reintroduction.

Sales at Tesco's British stores open over a year rose 0.9 percent in the 13 weeks to Feb. 27, its fiscal fourth quarter, building on growth at Christmas.

Tesco's better performance was broad based, with positive and improving underlying sales also achieved in Ireland (Other OTC: IRLD - news) , continental Europe and Asia and improved sales across all store formats and categories.

Former Unilever executive Lewis has impressed investors with his decisive steps since replacing the sacked Clarke (Toronto: CKI.TO - news) in September 2014.

His focus is on lower prices, streamlined product ranges, better customer service and new simplified relationships with suppliers, the root cause of the accounting issues that are the subject of a criminal investigation by Britain's Serious Fraud Office.

Lewis has also sold assets including Tesco's South Korean business, and cut costs, including thousands of jobs, to reduce the firm's net debt burden - down 40 percent year-on-year to 5.1 billion pounds.

He declined to comment on media reports of plans for further asset sales.

($1 = 0.7030 pounds) (Additional reporting by Emma Thomasson. Editing by Keith Weir)