UPDATE 3-Telefonica starts sale of O2 Germany stake

* Telefonica to list German unit around end of month

* 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 detail, investor comment)

By Clare Kane and Alexander Hübner

MADRID/FRANKFURT, Oct 3 (Reuters) - Telefonica SA started the sale of up to 20 percent of its O2-branded German unit, hoping to raise up to 1.5 billion euros ($2 billion) from a share offering designed to help cut the Spanish group's huge debts.

Announcing the intention to list its shares by the end of the year, Telefonica Deutschland attempted to stoke interest by saying it aims to pay a dividend next year totalling 500 million euros ($647 million) - contrasting with its parent's decision to cancel its payout for 2012.

The flotation is part of Telefonica's efforts to reduce its 57 billion euro debt pile and keep its prized investment-grade credit rating, under threat from troubles in its home market.

The company must raise between 7 billion euros and 8 billion a year through 2015 to cover debt repayments and risks rising refinancing costs if its credit ratings are cut. Crisis-hit Spain is expected to request a full state bailout as early as this weekend.

Telefonica did not say on Wednesday how much of Telefonica Deutschland it planned to float. The final size of the offer will depend on investor demand and price, said two financial sources, with marketing set to begin immediately for an IPO expected to go ahead around the end of the month.

One of the sources had said previously Telefonica aimed to list between 10 and 20 percent of Germany's smallest mobile operator, which it has valued at 10 billion euros.

The size of the offer may prove a key issue for investors, who tend to shy away from small partial listings, especially when they are under the control of a majority shareholder. A listing of 10 percent could therefore be too small to attract investors, said the sources.

One said the IPO should raise more than 1 billion euros but is unlikely to top 1.5 billion, with Telefonica Deutschland roughly valued at between 8 billion and 9 billion and only existing shares to be sold.


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

In Germany, 02 is the smallest mobile operator with roughly 16.4 percent of subscribers, trailing KPN's E-Plus , Deutsche Telekom and Vodafone .

"I think they're going to have to price it very cheaply, and they may well do because Telefonica needs the money," said Kevin Lilley, who manages the Old Mutual European Equity Fund in London. "Why would you be interested in the fourth player in Germany when the rest of the sector looks pretty cheap anyway?"

Lilley's fund does not currently hold Telefonica shares.

However, some analysts and bankers say room for growth makes Telefonica Deutschland a potentially attractive prospect, along with the promised dividend.

"We are operating in one of Europe's strongest economies and one of the biggest telecoms markets on the continent," Rene Schuster, chief executive of Telefonica Deutschland, said.

Telefonica Deutschland's net debt stood at 1.1 billion euros at the end of September.

The unit's 500 million euro dividend payout next year could make the dividend yield as high as 9 percent, depending on the final valuation of Telefonica Deutschland, though 6 to 7 percent is more likely, according to the sources.

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


"It's a reasonable dividend, but it's not going to attract yield investors," said Draper. "Nobody likes being a minority in this kind of situation, especially if you are a 10 percent minority, and especially if you are a minority to Telefonica."

Old Mutual's Lilley said investors would also be concerned that Telefonica had not disclosed the lock-up period for the shares, meaning it could list more of the unit in coming months.

Athole Skinner, analyst at Alliance Trust's European Equity Fund, which has not held Telefonica shares for almost three years and now only holds Kabel Deutschland in the sector, said the fund would be unlikely to buy shares in O2 Germany.

"It would come down to valuation. In terms of the telco sector, if anything I'd be more inclined to go for an incumbent with more exposure to fixed line, given the proposed changes to telecoms regulation announced this summer by the European Commission," said Skinner.

European regulators changed tack in July and backed away from forcing big telecom operators to charge smaller rivals less for renting space on their networks.

Telefonica Deutschland's dividend promise comes after its parent cancelled its own dividend for 2012, the first time it has passed its payout since the Spanish Civil War in the 1930s.

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 said Telefonica had the weakest credit profile of all of Europe's seven former state telecom operators.

($1=0.7731 euros)

(Reporting by Sonya Dowsett and Robert Hetz in Madrid, Harro Ten Wolde in Frankfurt and Chris Vellacott in London; Writing by Leila Abboud; Editing by Greg Mahlich and David Holmes)

((clare.kane@thomsonreuters.com)(+34 91 585 2130)(Reuters Messaging: clare.kane.thomsonreuters.com@reuters.net))