Is the Nokia-Microsoft deal a prelude to a merger?

Nokia and Microsoft have inextricably hitched their wagons to each other in the mobile market. Could this be a precursor to a mega technology merger?

Rumors of a Nokia-Microsoft merger first percolated last year, even before former Microsoft executive Stephen Elop took the reins at the troubled cell phone giant. And while many expected the company to at least be in discussions with Microsoft over a potential partnership, few had predicted the tight relationship announced in London this morning.

During a press conference at its annual investor meeting, the Nokia CEO and Microsoft's Steve Ballmer announced that Nokia will ditch its Symbian and Meego operating systems for Microsoft Windows Phone 7. Going forward Windows Phone 7 will be the predominate operating system for Nokia smartphones. The strategy is a bold one meant to combat the growing momentum by mobile competitors Google Android and Apple.

"We think this will make a three-horse race," Elop said during a press conference. "It's for Nokia and it's good for Microsoft. It allows us to move far faster than we could otherwise."

The partnership between the two companies goes much deeper than just an agreement to install Microsoft's OS on Nokia's phones. The companies plan to build products and services together as well as share strategic plans. The vision is to create a "third ecosystem" that can compete directly against Apple's iOS and Google's Android platforms.

The partnership described by the executives is so close that it doesn't take much to wonder why the companies didn't decide to simply merge. Perhaps they are testing the waters much like a couple moving in together before they take the plunge into marriage.

Regardless of whether they ever consummate their relationship with a merger, it's clear that Nokia's and Microsoft's fates will soon be inextricably linked. If either company fails in its execution of strategy, it will hurt the other, something that will likely irk investors.

The deal
Unlike other reseller deals, Microsoft and Nokia plan to combine assets and collaborate on joint marketing initiatives, as well as share development plans and build products together.

From Microsoft's perspective, the company will bring broader integration of software from all its different products as well as its Bing search capabilities and advertising platform, which Nokia can leverage on its devices. Meanwhile, Nokia, the world's largest handset maker, will bring its hardware expertise, its vast manufacturing and distribution scale, operator billing relationships, and its Navteq maps and navigation business.

Through this collaboration the companies expect that they will be able to drive more revenue into each other's pockets through mobile applications, services, social-networking integration and gaming via the Xbox product line.

Microsoft has forged many partnerships in the past. The company's core software business is predicated on strong relationships with key partners, such as Dell and Hewlett-Packard. And it's attempted to partner with other handset makers in the past to get a stronger foothold in the mobile market.

The mobile market, however, is very different from the PC market. And it's clear that Microsoft sees the value in Apple's model of owning both the hardware and software of a mobile device. Microsoft has already demonstrated its willingness to move into the hardware business with the Xbox. And it has built a successful ecosystem around the product.

But the Zune, Microsoft's attempt to challenge Apple's iPod, have not been as successful, showing that building hardware from scratch is not always the best strategy. Even acquiring hardware hasn't been an easily achievable path for Microsoft, as demonstrated by the acquisition of Sidekick maker Danger in 2008. The fruits of that acquisition was the Kin cell phone, which was only on the market a few short months before Microsoft killed the effort and focused on Windows Mobile 7.

Even as it pursued its own hardware strategy, Microsoft has continue to seek partnerships with other mobile-hardware makers. In 2003 it partnered with Motorola to develop smartphones, which culminated in the BlackBerry Curve, a supposed BlackBerry killer. More recently, in 2009 Microsoft partnered with LG, which also planned to use the now defunct Windows Mobile platform as its primary platform.

While Microsoft has clearly been down this path before with other cell phone makers, Ballmer said the relationship with Nokia is "unique." Elop agreed and explained that executives from Nokia and Microsoft were already working together to align strategy.

Elop admitted that Nokia had considered using Google Android as its primary software for smartphones. But he said the company decided against it because, he and his team feared that they'd not have enough control over the development of the ecosystem. He said he didn't think that Nokia's assets would be valued enough and that eventually it would turn Nokia's products into commodities.

"The Google option is a valid option," he said. "But at the end of the day it felt a little bit like giving up and not enough like fighting back."

Ostensibly, Nokia could face a similar problem in a partnership with Microsoft. Windows Phone 7 will not be exclusive to Nokia, which means that Nokia's rivals Samsung, LG, Motorola, and HTC will be able to use the platform as well.

But Elop believes that being beholden to Microsoft is less dangerous in terms of commoditizing Nokia's core attributes than a partnership with Google. He emphasized that Nokia has structured its deal with Microsoft so that it would have some control in the development of Windows Phone 7, much more control than other hardware companies also using the software. In this way, he believes Nokia will be able to differentiate its product from competitors' products.

"Another concern is there is some degree of loss of control or being locked in," he said."In terms of what we established, it's very clear we have taken steps [to ensure] these risks are not a significant factor. We're not disclosing terms, but our critical assessment was we had flexibility, a degree of control, in a way that allowed us to take advantage of our differentiation going forward. This is not your mother's OEM deal."

Elop said that any advances that Nokia makes in developing the Windows Phone 7 platform or in the ecosystem will be shared among all hardware partners so that Nokia's efforts will also benefit its competitors.

Of course, this raises an important question: How comfortable will Nokia's competitors be in participating in an ecosystem where the largest player in the market has more influence than they do?

Perhaps, HTC, Motorola, Sony Ericsson, LG Electronics, and Samsung, will double down their bets on Android. In that respect, Nokia could end up differentiating itself with Microsoft, because no one else will be willing to use the software. It could also pave the way for Nokia and Microsoft to merge into a single company.

Merger no easy road either
But mega mergers are never easy. Just getting the deals completed can be a challenge, as was the case with Microsoft's unrequited bid to acquire Yahoo. At least with Nokia and its new management team led by Elop, there is a friendly and possibly welcoming leader at the top.

But culturally Nokia and Microsoft are very different. Nokia is the pride of Finland. One former executive said that it was very telling that the company chose a Canadian instead of an American as its first non-Finnish CEO in its 150-year history. Being acquired by an American giant, such as Microsoft could be a hard pill to swallow for many at the company whose blood they say runs Nokia blue.

Then there is the question of Nokia's valuation. The company has a market capitalization of nearly $40 billion. Investors reacted negatively to the partnership announcement, which might indicate that a merger would be even less appealing to Wall Street. It didn't help that Nokia also announced lukewarm financial guidance as a result of the partnership for the coming year. Nokia said in a press release this morning that it "expects 2011 and 2012 to be transition years, as the company invests to build the planned winning ecosystem with Microsoft." After that the company's predictions for future growth are vague at best.

As a result after the deal was announced this morning, Nokia's stock in Helsinki, Finland, fell by almost 12 percent. The company's stock has been trading in heavy volumes in the U.S. all morning and shares are down.

Analysts had been hoping that Nokia would give up on its efforts to be a software maker and concentrate on building cool phones. But they likely would have preferred a relationship with Android, a strategy that has been successful for other handset makers.

Then of course there is history to contend with. While Elop and Ballmer claim that their product offerings complement one another, many people simply see Nokia and Microsoft as two slow-moving dinosaurs that have each tried but have been unable to crack the smartphone market on their own. Their common problem has been an inability to execute in a rapidly evolving market.

So it's hard to imagine that a combined version of the company--whether it be a strategic partnership or a merged company--would create a more nimble competitor to Google and Apple.

CNET's Stephen Shankland contributed to this report.