GM-UPDATE 2-Telefonica moves ahead with O2 Germany IPO

* Telefonica to list German unit by end-October

* Promises 500 mln euro dividend payout in 2013

* Listing part of programme to reduce 57 bln euro debt

* Telefonica smallest player in Germany, room to grow

(Adds analyst, source details)

By Clare Kane and Alexander Hübner

MADRID/FRANKFURT, Oct 3 (Reuters) - Telefonicastarted the sale of up to 20 percent of its O2-branded Germansubsidiary on Wednesday, with the company set to raise up to 1.5billion euros ($2 billion) from the initial public share offerwhich is now expected to go ahead later this month to help cutthe Spanish group's huge debts.

Announcing the intention to list its shares by the end of theyear, Telefonica Deutschland told potential investors that itaims to pay a dividend next year of 500 million euros ($647million) on its 2012 profits.

The flotation is part of Telefonica's efforts to reduce its57 billion-euro debt pile and keep its prized investment-gradecredit rating, under threat from the troubles in Spain.

The company must raise 7-8 billion euro s a year through 2015t o cover debt repayments and risks rising refinancing costs ifcredit ratings were cut.

Telefonica did not say on Wednesday how much of TelefonicaDeutschland it planned to float. The final size of the offerwill depend on now gauging investor demand and price, said twofinancial sources, with marketing to potential buyers set tobegin immediately.

One of the sources had said previously Telefonica aimed tolist between 10 and 20 percent of Germany's smallest mobileoperator, which it has valued at 10 billioneuros.

The liquidity of the newly listed entity will likely prove akey issue for investors, who tend to shy away from small partiallistings, especially when they are under the control of apowerful majority shareholder such as Telefonica.

A listing of 10 percent of Telefonica Deutschland wouldtherefore be too small to attract investors, said the sources.

One said the IPO should raise above 1 billion euros forTelefonica but is unlikely to top 1.5 billion euros, withTelefonica Deutschland roughly valued at around 8 billion to 9billion euros and only existing shares to be sold.

The company's executives will begin a roadshow ofpresentations to potential investors in around two weeks time.

In Germany, Telefonica's 02 brand is the smallest mobileoperator with roughly 16.4 percent of subscribers, trailingKPN's E-Plus , Deutsche Telekom and Vodafone.

However, analysts and bankers say room for growth makesTelefonica Deutschland an attractive prospect for investors,along with the promised dividend payment, which Telefonica saidwill increase in the coming years.

"We are operating in one of Europe's strongest economies andone of the biggest telecoms markets on the continent," ReneSchuster, Chief Executive of Telefonica DeutsGermany said.

Telefonica Deutschland's net debt stood at 1.1 billion eurosat end-September.

PAYOUT RATIO

The unit's 500 million-euro dividend payout next year couldmake the dividend yield as high as 9 percent depending on thefinal valuation of Telefonica Deutschland, though 6-7 percent ismore likely, according to the sources.

Will Draper, an analyst at Espirito Santo bank, questionedwhether the dividend would be enough to attract investors givenconcerns over the liquidity of such minority stakes.

"It's a reasonable dividend, but it's not going to attractyield investors," said Draper. "Nobody likes being a minority inthis kind of situation, especially if you are a 10 percentminority, and especially if you are a minority to Telefonica."

"There's a lot of risk there - you could be bought out byTelefonica in the future on an unfair basis."

The promise of a dividend payout in Germany comes afterTelefonica cancelled its own dividend for 2012, the first timeit has passed on a dividend since the Spanish Civil War in the1930s.

Other telecom operators in Europe such as France Telecom,KPN, and Telekom Austria have also sliced dividends this year.On Tuesday credit rating agency Standard & Poor's saidTelefonica had the weakest credit profile of all of Europe'sseven former state telecom operators.

The German listing will not make a huge difference to thecompany's huge debts but analysts say it will provide ready cashfor Telefonica at a time when it is hampered by high borrowingrates.

($1=0.7731 euros)

(Reporting by Sonya Dowsett and Robert Hetz in Madrid, HarroTen Wolde in Frankfurt, and Chris Vellacott in London; Writingby Leila Abboud; Editing by Greg Mahlich)

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Keywords: TELEFONICA GERMANY/