TOKYO, July 2 (Reuters) - Japan's largest retailer, Seven & I Holdings (3382.T), reported a 17.5 percent drop in first-quarter profit as cost-cutting failed to offset sharp sales declines at its department stores and supermarkets.

Seven & I

Seven & I and its rivals are suffering from a retail slump amid Japan's deepest post-war recession, as consumers defer buying clothing and non-essential items or defect to cheaper specialty stores such as apparel chain Uniqlo.

"The first half is the toughest period for the company. But when you consider the unusually steep sales drop since the Lehman shock last year, the negative trend is likely to soften later this year," said Shun Tanaka, a retail analyst at SMBC Friend Securities, referring to the collapse of U.S. investment bank Lehman Brothers in September.

"So in the second half, I expect its cost-cutting and efforts to improve profit margins to catch up with falling sales, leading to a profit recovery to a certain degree," he said.

Seven & I said its operating profit fell to 58.65 billion yen ($606 million) in the March-May quarter from 71.08 billion yen a year earlier.

The firm, which operates more than 12,000 Seven-Eleven stores in Japan and 6,300 in the United States, said sales continue to grow at its convenience store business.

But it said a stronger yen dented profits from its convenience store operations in the United States, while group earnings were also hurt by accounting changes.

Seven & I's supermarket chain Ito-Yokado and rival Aeon Co Ltd (8267.T) have been slashing prices and expanding offerings of cheaper store-brand items to lure back shoppers but they have failed to stem the sales decline.

The tough spending environment has also prompted the retailers to take a more drastic approach to overhauling their operations, converting unprofitable supermarkets into discount stores.

Seven-Eleven stores in Japan posted same-store sales growth during the first quarter, helped by higher tobacco sales after the introduction of ID-requiring cigarette vending machines. Many smokers have opted to buy tobacco at convenience stores rather than go to the trouble of registering for the special ID cards.

But the company has forecast almost flat same-store sales growth for the full year after a 5.2 percent increase the previous year, as the effect of the tobacco-sales boost will disappear in year-on-year comparisons later this year.

For the full year ending in February, Seven & I kept its forecast for 1.1 percent growth in operating profit to 285 billion yen, slightly above an average forecast of 282.8 billion yen in a poll of 18 analysts by Thomson Reuters.

Shares of Seven & I have shed about 25 percent so far this year, underperforming a 7 percent fall in the Tokyo stock exchange's retail subindex .IRETL.T.

On Thursday 2 July, the stock ended up 0.2 percent before the announcement, against a 0.3 percent decline in the retail subindex.

(Reporting by Taiga Uranaka; Editing by Chris Gallagher)