* Q1 adjusted EPS $0.14, handily tops estimate
* Sales fall 1.5 percent to $5.16 billion
* Shares spike 18 percent at midday (Updates share move, adds Safeway results)
July 18 (Reuters) - Supervalu Inc reported a better-than-expected adjusted quarterly profit after the significantly downsized supermarket operator slashed costs and shed workers, sending its heavily-shorted shares soaring more than 18 percent.
Supervalu's stock jumped $1.22 to $7.99 in midday trading on the New York Stock Exchange. The exaggerated move appeared to be a classic short squeeze as traders who bet against the stock scrambled to cover their positions.
"This is a very highly shorted stock and it makes sense that after a strong earnings report, these bearish speculators would be rushing to close their positions," said Joe Bell, senior equity analyst at Schaeffer's Investment Research.
More than 26 percent of Supervalu's shares outstanding are shorted, Bell said. Based on Supervalu's average daily stock volume, it would take nearly 10 days for the shorts to buy back their positions, he said.
Rival Safeway Inc, which recently announced the sale of its Canadian assets and spun off its Blackhawk gift card unit, also reported results that topped Wall Street's view.
Shares in the operator of Safeway, Vons and Dominick's stores jumped 6.3 percent to $26.20.
Short interest in Safeway's outstanding shares is 20 percent versus just 2.3 percent for industry leader Kroger, according to shortsqueeze.com. Average short interest is around 3 percent.
Supervalu, which recently sold nearly 900 supermarkets in a $3.3 billion deal, has been slimming down its business to adjust to its smaller size. It also had been losing customers to larger rivals such as Kroger and Wal-Mart Stores Inc, which sells more groceries than any other U.S. retailer.
Supervalu sold its Albertsons, Acme, Jewel-Osco, Shaw's and Star Market stores, along with Osco and Sav-on in-store pharmacies, in March to an investor group led by Cerberus Capital Management LP.
Supervalu's net loss from continuing operations rose to $105 million, or 43 cents per share, in the first quarter ended June 15, from $18 million, or 8 cents per share, a year earlier.
However, excluding items the company earned 14 cents per share. Analysts on average had expected a profit of 6 cents per share on that basis, according to Thomson Reuters I/B/E/S.
The company said its gross margin improved to 13.8 percent from 13.5 percent, helped by lower infrastructure costs.
Sales fell 1.5 percent to $5.16 billion, slightly below the average market estimate of $5.17 billion, due to a drop in same-store sales.
(Reporting by Lisa Baertlein in Los Angeles, Doris Frankel in Chicago and Maria Ajit Thomas in Bangalore; Editing by Saumyadeb Chakrabarty, Maju Samuel, Nick Zieminski, Chris Reese and Kenneth Barry)