* To spend more than expected, earlier than expected
* Suffers record drop in Q2 organic service revenue
* Hit by regulation, recession in Europe
* Vodafone shares up 0.6 pct, while telecoms index down
By Kate Holton
LONDON, Nov 12 (Reuters) - Britain's Vodafone will spend 7 billion pounds - more than expected and earlier than expected - to increase the speed and coverage of its networks and reverse a record fall in revenues resulting from its struggling European business.
The world's second-largest mobile operator, which is using some of the proceeds from the $130 billion sale of its U.S. arm to upgrade its infrastructure, said it would spend 3 billion pounds in Europe, 1.5 billion in its emerging markets and the rest on fixed-line assets, enterprise and its retail arm.
It will complete the programme by March 2016 - a billion pounds more than expected and a year earlier than forecast - to meet the demand of consumers who want on-the-go internet access via smartphones and tablets.
"We expect that during the next three to five years, Europe will definitely improve," Chief Executive Vittorio Colao told reporters. "Therefore, we prefer to have a stronger, more performing and more differentiated operation by then so that we can come out at a higher speed than everybody else."
Shares in Vodafone were up 0.6 percent at 228.75 pence at 1405 GMT, outperforming the European telecoms index, which was down 0.7 percent.
The group, which is seen as a possible bid candidate for U.S. giant AT&T, set out the details of its "Project Spring" spending programme as it reported first-half results showing the pressures across the group.
Organic service revenue, which strips out items such as handset sales, currency and acquisitions, was down a worse than expected 4.9 percent in the second quarter due to regulator-imposed price cuts and fierce competition in Italy, Spain, Germany, Turkey and Britain. Civil unrest in Egypt also hit demand.
The 4.9 percent second quarter fall was worse than the 3.5 percent drop recorded in the first quarter and well below the last record fall of 4.2 percent in the fourth quarter.
In the three months to the end of September, organic service revenue was down 4.9 percent in northern and central Europe, down 15.5 percent in southern Europe and up 5.7 percent in its emerging markets such as India and South Africa.
Credit rating agency Moody's said on Tuesday it expected a fifth year of revenue decline in 2014, though operating margins would stabilise, helped by cost cutting and the end of regulatory cuts to mobile call termination fees.
"We view the decision to accelerate and expand Project Spring positively, given it brings forward the commercial benefits and increases competitive pressure on Vodafone's indebted and sub-scale rivals," Goldman Sachs said in a note.
Vodafone said the spending plans would take 0.6 billion pounds off its core earnings in the 2015 financial year. It expects the investment to result in incremental free cash flow of over 1 billion pounds in the 2019 financial year, and it otherwise reiterated its 2014 outlook.
Vodafone will now invest a total of 19 billion pounds over two years, when the Project Spring spending is added to regular investment of 12 billion pounds over that period. Colao said the expected improvement in the European economy would combine with an expected increase in the usage of data-hungry smartphones, making the improved network a necessity.
"We are laying strong foundations for the future," Colao said. "The two years ahead will see the largest and fastest period of network investment in our 25-year history."
Colao said he expected Vodafone's strongest rivals, likely to include Telefonica, Deutsche Telekom and Orange, to follow suit while smaller rivals would likely struggle.
Moody's agreed: "Not many incumbent operators have the financial flexibility to match this, and the challengers ... have even less financial flexibility because of their high leverage."
Strong growth in data consumption by smartphones, tablets and other devices means network quality is becoming more important in the fight to win and keep customers.
With that in mind, Vodafone decided to plough some of the proceeds from the sale of its 45 percent in Verizon Wireless into infrastructure. But the bulk of the windfall from Verizon Communications - $84 billion - will be handed to shareholders, and the rest used to cut debt.
Vodafone said its decision to invest had also been driven by a belief that it should see softer regulation from Brussels, which has spent years forcing down roaming and other call fees.
The group also recognised additional deferred tax assets of 17.7 billion pounds in relation to the group's historical tax losses. It said this would not have any impact on the tax it pays, but analysts said it could prove attractive to a possible suitor.
Bankers have told Reuters that AT&T is scouting for targets in Europe, with Vodafone the leading candidate - a bold bid that would provide instant scale across the region - but Colao declined to comment on whether he expected a deal to take place.