UPDATE 2-Debenhams warns on profit after price cuts fail to lure shoppers

* Shares fall by a fifth after profit warning

* UK sales down 2.6 percent over last 17 weeks

* Muddies picture for retailers after Next shines (Adds background, shares)

LONDON, Jan 4 (Reuters) - British department store operator Debenhams Plc slashed its annual profit forecast on Thursday after it was forced to cut prices to drive Christmas gift sales, hammering its shares and putting the stock on track for its worst ever daily fall.

The downturn at the 240-year-old group illustrates the struggle traditional British retailers face against online competition, a decline in demand for clothing and pressure on consumer spending.

Debenhams said its underlying British sales fell 2.6 percent in the 17 weeks to 30 December, reflecting a "volatile and competitive market" in the months before Christmas and a disappointing first week of its sale after Dec. 25.

Shares fell 20 percent and weighed on fellow retailers such as Marks & Spencer, just a day after an upbeat statement from Next raised hopes that retailers had defied forecasts for gloomy Christmas trading.

"The market has been challenging and particularly promotional in some of our key seasonal categories and we have responded in order to remain competitive for our customers, which has impacted our profit performance," Debenhams Chief Executive Sergio Bucher said.

Debenhams, Britain's second-biggest department store operator which trades from over 240 stores across 27 countries, is in the midst of a transformation program to close some stores and revamp the others.

It said it managed to increase like-for-like sales by 1.2 percent in the six weeks to Christmas after it cut the price of gifts. With shoppers failing to return to the stores after Christmas, it cut prices again, at a heavy cost to its margins. It said its gross margin for the first half would now be down by about 150 basis points, far below its target of a 25 basis point fall for the year to September 2018. It said its profit before tax for the year was now likely to be in the range of 55 million to 65 million pounds ($88 million).

Debenhams reported underlying profit before tax of 95 million pounds last year and analysts had been expecting a figure of 83 million pounds in 2018, according to Reuters data.

Analysts at Liberum, who have a "sell" rating on the stock, said the lower margin would have a 35 million pound impact on gross profit, offset only partly by 10 million pounds of additional cost savings.

They cut their profit target by 35 percent to 52.1 million pounds. ($1 = 0.7399 pounds) (Reporting by Paul Sandle; editing by Kate Holton and Keith Weir)