By James Davey and Kate Holton
LONDON (Reuters) - Britain's biggest retailer Tesco reported its best quarter of UK underlying sales growth for over five years and more growth over Christmas, continuing a major recovery in its fortunes, though it cautioned it would not be immune to inflationary pressures.
Tesco (TSCO.L), which like rivals has been battling the rise of German discounters Aldi [ALDIEI.UL] and Lidl [LIDUK.UL] and has also had to deal with the fallout from an accounting scandal in 2014, said on Thursday progress across the group meant it could reiterate forecasts for its 2016-17 financial year.
"We look at the performance over the last four months and say it's another significant step in the turnaround of the business," Chief Executive Dave Lewis told reporters.
Tesco said it was on track to deliver a group operating profit before exceptional items of "at least" 1.2 billion pounds in 2016-17, up from 944 million in 2015-16.
Lewis, who has simplified and transformed Tesco's operations since joining in 2014, said that was an indication the outcome "may be ever so slightly more."
Shares in Tesco have increased 29 percent over the last year, but were down 2.1 percent by 1248 GMT.
That reflected a strong run this week ahead of the sales update and the fact that, unlike smaller rivals Morrisons (MRW.L) and Sainsbury's (SBRY.L), Tesco met, rather than surpassed, analysts' expectations.
"This is a good statement, albeit perhaps not good enough for the ‘uber’ bulls," said Shore Capital analyst Clive Black, who has a "hold" rating on the stock.
Other analysts, however, expressed concern about slowing UK sales momentum in the closing weeks of 2016 and international sales below expectations. Some highlighted flagging general merchandise sales too.
"Tesco was quick to pinpoint the decision not to repeat last year’s Clubcard 'Boost' promotion as the reason for this, but it seems likely that competition from Sainsbury’s Argos played its part," said David Alexander, analyst at Verdict Retail.
Investors have also expressed concern about a potential squeeze on UK consumer spending this year as inflation, driven by sterling's devaluation since Britain's vote in June to leave the European Union, begins to erode real earnings growth.
“We haven’t seen anything that would support that,” said Lewis, noting no change in consumer behaviour in the early weeks of January.
He said grocery price deflation had, however, eased over Tesco's third quarter and the Christmas period.
“Inflationary pressure is there and in a number of categories it’s been too significant to fully offset,” he said, pointing to rises in the price of pork and cheese.
“Our commitment is to keep doing everything we can to minimise the impact ... Inflation is not something we welcome."
Tesco said sales at UK stores open over a year rose 0.7 percent in the six weeks to Jan. 7, in line with analyst forecasts which ranged 0.3 to 1.5 percent.
"On every customer metric we improved year-on-year – on range, quality, price, service and availability," said Lewis,
The Christmas performance built on UK like-for-like sales growth, also reported on Thursday, of 1.8 percent for the 13 weeks to Nov. 26, Tesco's fiscal third quarter - at the top end of analysts' forecasts and a fourth straight quarter of underlying growth.
The quarter also marked a first market share gain since 2011.
Underlying UK sales had risen 0.9 percent in Tesco's second quarter.
By 2020, Lewis wants Tesco to earn between 3.5 pence and 4 pence of operating profit for every 1 pound spent by shoppers, up from 2.18 pence in the first half of 2016-17, as sales rise and costs are cut through efficiencies in stores and in its distribution network.
Underlying international sales fell 1.2 percent in the Christmas period. Tesco highlighted intense competitive activity in Poland and a weak market in Thailand following the death of King Bhumibol Adulyadej.
(Editing by Guy Faulconbridge and Mark Potter)