By Robert Hetz
MADRID (Reuters) - Spanish telecoms group Telefonica (TEF.MC) has a big Italian headache.
Six years ago it bought a chunk of Telecom Italia (TIT.MI), which at the time was seeking a "white knight" to put off what the Italian government saw as less palatable foreign suitors.
Now the Italian investors who together with Telefonica control Telecom Italia are prepared, in varying degrees, to sell their shares when they get their first opportunity to leave the shareholder pact on September 28, sources have said.
That could force Telefonica to make a tough decision - either sell out, taking a further loss on its investment, or cough up money it does not have to maintain its influence.
What makes the call particularly tricky for the Spanish company is that its Telecom Italia holding has helped it protect its 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 deliberations about Telecom Italia's Brazil unit, the Spanish firm has benefited over the years from having a say over the strategy and operations of one of its rivals in Latin America.
Now that situation is under threat.
Telefonica's best hope may be to persuade its Telecom Italia partners to stay on, since the other three options look unpalatable: selling out at a steep loss, increasing debt to fight off other bidders or merging with the struggling company.
Analysts say Telefonica won't bid first but would counterbid if anyone else tries to take control.
"As long as the status quo remains ... Telefonica will more than likely remain as it is in Telecom Italia," Fabian Lares, analyst at brokerage JB Capital Markets, said in a note. "It would only see its hand tipped, in our opinion, if an outsider made a move on Telecom Italia or its Latin American assets."
A Telefonica spokesman declined to comment on the company's options around its Telecom Italia investment.
Telecom Italia - in which Telefonica has an indirect 10.5 percent stake through its 46 percent share of holding company Telco, formed with Italian investors Mediobanca (MB.MI), Intesa Sanpaolo (ISP.MI) and Generali (MIL:G) - has so far made no direct comment on Telefonica's position.
Telecom Italia Chairman Franco Bernabe said on Friday only that he wanted any new investor to be an industry player with a vision for the company.
It's not just the itchy feet of Telecom Italia's local investors which are seen making it ripe for takeover. Prospects of a sector shakeup rose in the wake of Verizon Communications' (VZ) $130 billion buyout of British operator Vodafone (VOD.L) from their U.S. wireless business.
Telecom Italia investor Marco Fossati last week urged Telefonica to decide what to do with its stake in the Italian group and said the time was right to join a consolidation wave.
"Telefonica must decide: either it sells its stake to make way for other telecom players or it merges with Telecom Italia," Fossati told Reuters.
But Telefonica has been focused on cutting its close to 50 billion euros of debt, built up during a long spending spree, and would jeopardize its credit rating if it sinks more money into Telecom Italia.
Some see a Telefonica-Telecom Italia merger as unlikely. "If there has been no merger between them so far, it's because Telefonica has not wanted it," said a source familiar with Telefonica's thinking.
The struggling Italian firm's board meets on September 19 to discuss how to push the company forward, including a possible change of the shareholder structure. For Telefonica an exit would be painful. The Spanish firm invested an estimated 2.7 billion 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 projected losses from its investment, based on a drop in the Italian firm's shares to 1.2 euros from 2.6 euros. But the stock is now even lower at 0.6 euros.
It was not clear what a breakup of Telco would imply for Telefonica's portion of the holding company's 2.6 billion euros in debt.
"Telefonica will want to hang on to its stake in Telecom Italia because at current prices, the sale would mean its debt would increase (by) 500 million euros and it would also have to account for losses in Telecom Italia's share price," said Andres Bolumburu at Banco Sabadell.
One telecommunications analyst, who asked not to be named, said: "Buying out the Telco partners would be a very expensive option, it could cost more than 1.5 billion euros."
Telefonica could risk its investment-grade credit rating if it takes on even more debt, having said in July it would buy E-Plus, the German arm of KPN (KPN.AS), for 8.1 billion euros.
Telefonica has pledged to get debt to below 47 billion euros this year and Moody's rating agency has warned that failing to hit that goal would put the credit score at risk.
"A rating downgrade could result if Telefonica deviates from its financial strengthening plan," Moody's said in a note.
(Additional reporting by Elisabeth O'Leary; Writing by Fiona Ortiz; Editing by David Holmes)