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By Robert Hetz
MADRID, Sept 9 (Reuters) - Spanish telecoms group Telefonica has a big Italian headache.
Six years ago it bought a chunk of Telecom Italia,which at the time was seeking a "white knight" to put off whatthe Italian government saw as less palatable foreign suitors.
Now the Italian investors who together with Telefonicacontrol Telecom Italia are prepared, in varying degrees, to selltheir shares when they get their first opportunity to leave theshareholder pact on Sept. 28, sources have said.
That could force Telefonica to make a tough decision -either sell out, taking a further loss on its investment, orcough up money it does not have to maintain its influence.
What makes the call particularly tricky for the Spanishcompany is that its Telecom Italia holding has helped it protectits position in important growth markets in Latin America.
The two European firms are rivals in Brazil and Argentina,where they control the two biggest mobile telephone operators.
Although Telefonica is excluded from board deliberationsabout Telecom Italia's Brazil unit, the Spanish firm hasbenefited over the years from having a say over the strategy andoperations of one of its rivals in Latin America.
Now that situation is under threat.
Telefonica's best hope may be to persuade its Telecom Italiapartners to stay on, since the other three options lookunpalatable: selling out at a steep loss, increasing debt tofight off other bidders or merging with the struggling company.
Analysts say Telefonica won't bid first but would counterbidif anyone else tries to take control.
"As long as the status quo remains ... Telefonica will morethan likely remain as it is in Telecom Italia," Fabian Lares,analyst at brokerage JB Capital Markets, said in a note. "Itwould only see its hand tipped, in our opinion, if an outsidermade a move on Telecom Italia or its Latin American assets."
NEW INVESTOR
A Telefonica spokesman declined to comment on the company'soptions around its Telecom Italia investment.
Telecom Italia - in which Telefonica has an indirect 10.5percent stake through its 46 percent share of holding companyTelco, formed with Italian investors Mediobanca,Intesa Sanpaolo and Generali - has so farmade no direct comment on Telefonica's position.
Telecom Italia Chairman Franco Bernabe said on Friday onlythat he wanted any new investor to be an industry player with avision for the company.
It's not just the itchy feet of Telecom Italia's localinvestors which are seen making it ripe for takeover. Prospectsof a sector shakeup rose in the wake of Verizon Communications' $130 billion buyout of British operator Vodafone from their U.S. wireless business.
Telecom Italia investor Marco Fossati last week urgedTelefonica to decide what to do with its stake in the Italiangroup and said the time was right to join a consolidation wave.
"Telefonica must decide: either it sells its stake to makeway for other telecom players or it merges with Telecom Italia,"Fossati told Reuters.
But Telefonica has been focused on cutting its close to 50billion euros of debt, built up during a long spending spree,and would jeopardize its credit rating if it sinks more moneyinto Telecom Italia.
Some see a Telefonica-Telecom Italia merger as unlikely. "Ifthere has been no merger between them so far, its becauseTelefonica has not wanted it," said a source familiar withTelefonica's thinking.
POSSIBLE CHANGE
The struggling Italian firm's board meets on Sept. 19 todiscuss how to push the company forward, including a possiblechange of the shareholder structure. For Telefonica an exitwould be painful. The Spanish firm invested an estimated 2.7billion euros for a stake that is now worth 830 million.
"It's very tough for Telefonica to manage a dignified exit,"said Javier Mielgo, analyst with brokerage Mirabaud in Madrid.
Telefonica has already provisioned 1.58 billion in projectedlosses from its investment, based on a drop in the Italianfirm's shares to 1.2 euros from 2.6 euros. But the stock is noweven lower at 0.6 euros.
It was not clear what a breakup of Telco would imply forTelefonica's portion of the holding company's 2.6 billion eurosin debt.
"Telefonica will want to hang on to its stake in TelecomItalia because at current prices, the sale would mean its debtwould increase (by) 500 million euros and it would also have toaccount for losses in Telecom Italia's share price," said AndresBolumburu at Banco Sabadell.
One telecommunications analyst, who asked not to be named,said: "Buying out the Telco partners would be a very expensiveoption, it could cost more than 1.5 billion euros."
Telefonica could risk its investment-grade credit rating ifit takes on even more debt, having said in July it would buyE-Plus, the German arm of KPN, for 8.1 billion euros.
Telefonica has pledged to get debt to below 47 billion eurosthis year and Moody's rating agency has warned that failing tohit that goal would put the credit score at risk.
"A rating downgrade could result if Telefonica deviates fromits financial strengthening plan," Moody's said in a note.
