UPDATE 2-T.Italia, Telefonica merger talks under way -sources

* Talks at early stage, no plan yet – sources

* Telefonica wary due to T.Italia debt, Latam – sources

* Rome remains wary – sources

* Telecom Italia spike after comments then shed gains

(Adds details on size of deal, updates shares)

By Stefano Rebaudo

MILAN, Feb 12 (BestGrowthStock) – Talks have begun for Spain’s
Telefonica (TEF.MC: ) to create Europe’s biggest telecom operator
by buying smaller partner Telecom Italia (TLIT.MI: ), sources
said, provided it can overcome political distaste in Italy.

Italian sources close to the matter said both the Spanish
company and the Italian government remained cautious about a
deal, with one adding that no transaction was likely before
regional elections in Italy at the end of March.

Telecom Italia shares spiked higher for a while after the
comments but were back down 0.1 percent at 1.089 euros at 1436
GMT. Telefonica shares were unchanged.

“What the outcome will be is difficult to say. The truth is
that the talks are still at a preliminary level,” the source
said. “The issue is being discussed, but it will be difficult to
have a decision before the regional elections.”

Telefonica, Europe’s No. 2 telecom operator, declined to
comment.

Speculation about a deal between the companies has heated up
in recent weeks, spurring a rally in Telecom Italia stock but
drawing opposition from politicians in Rome who are wary of
allowing the country’s phone network to fall into foreign hands.

Telefonica is the biggest shareholder in the Telco investor
pact that controls Telecom Italia and has long been considered a
logical buyer for the company, though a green light from Rome
would be essential for any deal.

With market capitalisation of 76 billion, Telefonica is
nearly four times the size of Telecom Italia, Europe’s No. 5
telecom operator, which is worth almost 20 billion euros on the
market.

Analysts at HSBC on Friday estimated a purchase of Telecom
Italia could cost up to 25 billion euros, which they said would
be expensive and probably unnecessary unless the Italian company
could show a big turnaround in operations.

Telefonica has a relatively low debt level of two times
EBITDA and expects free cash flow of more than 40 billion euros
in the 2009-2012 period, much of which is spent on dividends.

PRESSURE FROM MADRID?

The source played down recent comments from Prime Minister
Silvio Berlusconi’s government suggesting it had a hands-off
policy on such matters.

“The most accurate reading at the moment seems to be that
the government is giving the appearance of openness towards a
tie-up, in response to certain pressures from Spain, and which
have to do with other Spanish dossiers,” the source said.

An Italian source close to the matter previously said
Italian banks were lobbying for a tie-up between Spain’s Abertis
and Italy’s Atlantia (ATL.MI: ) to set the stage for a reciprocal
takeover of Telecom Italia by Telefonica. [ID:nLDE60Q0Y0]

A second source said the government was worried about
political attacks over not saving the Italian identity of
Telecom Italia in a deal, especially after it blocked the sale
of airline Alitalia to Air France-KLM (AIRF.PA: ).

Telefonica is also moving cautiously because of Telecom
Italia’s 35.5 billion-euro debt load, while Italian investors in
Telco may be willing to exit or become shareholders in the new
combined group, the first source said.

Telco, which holds 22.45 percent of Telecom Italia, includes
Italian banks Intesa Sanpaolo and Mediobanca and insurer
Generali alongside Telefonica.

LATAM HURDLE?

Latin America, where the two companies have overlapping
operations, could be a bigger hurdle.

Faced with antitrust issues, Telefonica would probably try
to retain Telecom Italia’s Tim Brasil (TCSL4.SA: ) unit rather
than Brazilian telecom Vivo (VIVO4.SA: ), which it controls along
with Portugal Telecom (PTC.LS: ), said the first source.

A third source said the combined group would prefer to
control Tim Brasil rather than half of Vivo, which is Brazil’s
largest mobile phone carrier.

Stock Market

(Additional reporting by Robert Hetz in Madrid, Writing by
Deepa Babington; editing by John Stonestreet/Will Waterman)

UPDATE 2-T.Italia, Telefonica merger talks under way -sources