* Sees signs of recovery in Italy
* Lower Italian sales, Brazil currency weigh on 2013 results
* Shares end 2.6 percent lower in volatile trading (Adds quotes, context, shares)
MILAN, March 7 (Reuters) - Telecom Italia scrapped its annual payout to most shareholders for the first time on Friday, to help fund the massive investment its network needs to better compete with rivals.
However, Italy's largest phone company by market share said it will pay all shareholders a dividend from next year, reflecting signs of recovery in domestic demand after a deep recession and easing competition in the mobile phone market.
Under new Chief Executive Marco Patuano, the heavily indebted group is selling non-core assets and investing in faster networks to compete against rivals such as Britain's Vodafone, the second-largest operator in Italy.
Scrapping the 2013 dividend on ordinary shares will save Telecom Italia about 290 million euros ($402 million), a fraction of the approximately 3 billion euros a year it plans to invest in Italy over the next three years.
European rivals have also reduced their payouts to investors. Deutsche Telekom cut its dividend for 2013 and beyond by nearly one third because it needed cash for investments in its U.S. and European networks.
"Suspending dividends on the ordinary shares means more funds for fibre and LTE (faster 4G network) in Italy," Patuano, who took the helm in October, said on a conference call after the company announced full-year results.
"Early evidence of a gradual recovery in domestic market trends makes us confident we'll pay a dividend on both classes of shares next year."
Savings shareholders, who have no voting rights and own only a small portion of the company's capital, will receive a 0.0275 euro-per-share dividend on 2013 results, the minimum required by its bylaws.
Telecom Italia cut net debt by 5.2 percent to 26.8 billion euros at the end of December, ahead of analysts' forecasts. Savings on interest payments could be ploughed into products such as broadband, where demand is rising.
The fall in revenue from its core Italian operations slowed to 7.7 percent in the last quarter of 2013 from 9.1 percent in the previous three months, as economy began a tentative recovery from its worst post-war recession.
Domestic revenue accounted for 69 percent of group's total income last year, with the rest coming mainly from Brazil.
"This set of results should reassure investors of the slight improvement of the domestic trend," Fabio Pavan, an analyst at Mediobanca, said in a note to clients.
Year-to-date, Telecom Italia shares have gained 13 percent, outpacing a 9 percent rise in the Italian all-share index. On Friday the stock fell 2.6 percent after a volatile session, while the European telecoms index declined 1.4 percent.
Patuano said Telecom Italia was in favour of consolidation in its home market where there are four mobile network operators.
"We can help but not drive it," he said, suggesting his company could buy assets or frequencies that might be put up for sale if two of its competitors merged.
There has been market speculation about a possible tie-up between Vimpelcom's Wind and Hutchison Whampoa's Three Italia, the country's third- and fourth-largest operators respectively. Both have declined to comment.
Telecom Italia is unlikely to be involved in any takeovers due to antitrust issues.
The company said it expects the Italian market's decline to slow this year, while its second-largest market Brazil, where it is present through mobile unit TIM Brasil, should grow.
In 2013, overall revenue and core profit declines were broadly in line with analysts' expectations.
$1 = 0.7225 euros $1 = 0.7214 euros Reporting by Danilo Masoni; Editing by Erica Billingham