* Cuts full-year profit forecast, interim dividend
* Shares down by 8 percent at the open
* New CEO Lewis to start one month early
* Rivals' shares down on fears of a wider price war (Adds quotes, detail, link to graphic)
By Kate Holton and Neil Maidment
LONDON, Aug 29 Tesco will slash its dividend and investment spending to give its new boss more firepower to rebuild Britain's biggest retailer, after a second profit warning in two months showed the scale of the task he faces.
The grocer said on Friday that as a result of its worsening performance, former Unilever turnaround specialist Dave Lewis would start on Monday - a month earlier than planned - with a remit for a major review of the 95-year-old business.
The latest profit warning lays bare the need for a change at a company once considered an unstoppable engine of growth, with annual trading profit now expected to come in around 25 percent lower than last year - a third straight year of decline.
Analysts said the 75 percent cut in the half-year dividend to 1.16 pence per share was much deeper than expected, but it would give Lewis greater flexibility to revive the world's No.3 retailer, such as by cutting prices.
Shares in Tesco, which have been languishing near a 10-year low, slumped 6 percent to wipe around 1.2 billion pounds off its market valuation. An initial fall of 8.5 percent was its greatest single drop in two and a half years.
"We are not expecting a quick turnaround," said Niall Dineen, a portfolio manager at AGF International Advisors, who increased his holding in Tesco on Friday morning.
"We think it will be a couple of years for margins to recover and we think the share price could be under pressure for a while."
Rival Sainsbury's fell 4.5 percent and Morrisons dropped 4 percent on fears that Lewis could plough cash into slashing prices and spark an industry-wide battle.
"We see this as "clearing the air" ahead of a strategy reset involving a significant reduction in pricing and, potentially, further asset disposals outside the UK," Standard & Poor's analyst Carl Short said.
Tesco has been hit by fierce competition from discounters at the lower end of the market as well as by rivals at the top, and by changing British shopping habits.
The big out-of-town stores it long championed are now less in demand, with more people preferring to shop little and often at local stores or buy online. Costly mistakes abroad, such as a failed U.S. venture, have also taken their toll on Tesco.
Britain's largest private sector employer, with over 500,000 staff, started losing ground in its key home market in the latter years of CEO Terry Leahy's tenure, after he had transformed the company into the clear market leader.
His successor Philip Clarke, who spent more than 1 billion pounds on a failed recovery plan, issued his first profit warning in January 2012, and another in July as he quit.
With industry data showing Tesco's UK market share continuing to slide at an alarming rate, the company turned to Lewis as its first external CEO appointment in its history.
"The board's priority is to improve the performance of the group," Chairman Richard Broadbent said.
"Our new Chief Executive, Dave Lewis, will now be joining the business on Monday and will be reviewing every aspect of the group's operations. This will include consideration of all options that create value for customers and shareholders."
Data on Wednesday showed Tesco's sales decline had worsened, hurt by the weakest overall market growth in a decade, with its sales down 4.0 percent year on year in the 12 weeks to Aug. 17.
Its market share has dipped to 28.8 percent from the 30.7 percent it held when Clarke took over in March 2011, as it lost ground both to discounters Aldi and Lidl and upmarket grocers such as Waitrose.
Rivals Sainsbury's and Wal-Mart's Asda have remained largely stable while Morrisons, the country's fourth largest player, has also struggled.
The cut to the interim dividend, which analysts estimate could save Tesco 800-900 million pounds assuming a similar cut to the final dividend, and the 400 million pound reduction in capital spending on IT and store revamps will give Lewis greater financial firepower to cut prices and win back shoppers.
Other more radical options open to the new boss include a shake-up of Tesco's store structure to create different formats for different areas, including a chain to compete with discounters, one to target the mid-market and a third to challenge the upmarket sector.
Its brand and image could also be revamped, costs and staffing numbers could be cut, while international units could be sold or spun off.
"Dave is really keen to get started and the board recognised the need to get on and address these challenges," a source familiar with the situation told Reuters.
Clarke, a 40-year Tesco veteran, will remain on hand to help with the transition through to January.
Analysts at Shore Capital said the rest of the company's management also needed an overhaul, a view echoed by ex-Tesco directors speaking to Reuters earlier this month.
"This update fundamentally raises questions in our minds about the capability of the management under Clarke at this once great company... We expect ... there to be considerable senior management change under Lewis in time," the analysts said.
Lewis will be joined in December by new Chief Finance Officer Alan Stewart, who announced in July he would quit Marks & Spencer to join Tesco.
The Tesco tactics appear to be following the same route as those taken by Sainsbury's in 2005 when Justin King halved the dividend and its margins in order to fund a swathe of price cuts designed to get customers back into its stores.
The dividend cut will come as a blow though to those attracted by its 6 percent yield, compared with the average FTSE 100 company yield of 3.8 percent. With profits falling, analysts had said the pay-outs had become unsustainable.
Tesco now expects trading profit for 2014/15 to be in the range of 2.4-2.5 billion pounds ($4.0-$4.2 billion), compared with an analyst forecast range of 2.7-2.8 billion pounds.
Lewis could present some initial thoughts to the market on Oct. 1 at Tesco's half-year results, when the firm expects to report an interim trading profit of around 1.1 billion pounds. ($1 = 0.6030 British Pounds) (Additional reporting by Paul Sandle, Emma Thomasson and Nishant Kumar; Editing by Mark Potter and Tom Pfeiffer)