Nokia survives with feature phones but WP7 challenge awaits

Nokia (s nok) eked out a decent third quarter based on strong feature phone sales, helping the company beat analyst expectations. Nokia’s revenue fell 13 percent to 8.98 billion euros ($12.3 billion), with handset shipments decreasing by 3 percent to 106.6 million units (89.9 million feature phones and 16.8 million smartphones), a more gentle decline than analysts had predicted. It managed a diluted earnings per share of 0.03 euros, beating out analysts expectations of a 0.01 euro loss.

The news has sparked some excitement around Nokia’s stock, which is up in the hopes that the company is managing its transition well and may be turning a corner. But the real challenge awaits as Nokia prepares to unveil its first Windows Phone devices next week at Nokia World, beginning to show how its big bet on Microsoft’s (s msft) mobile operating system will play out. That’s where Nokia will need to make its stand, because it can’t rely on feature phones, which will only become more like smartphones over time.

Smartphone penetration continues to grow, and feature phones are increasingly going to be left behind. The average selling price of low-end phones plummeted 20 percent year over year, dropping Nokia’s operating margins to 2.4 percent compared with 11.3 percent a year earlier. The future for Nokia is in smartphones, a market it used to lead with its Symbian devices, which have fallen behind Android (s goog) and iPhone (s aapl) devices in popularity with many consumers. Nokia’s smartphone sales fell to 16.8 million units in the third quarter, down 38 percent year over year and up just 1 percent sequentially from the second quarter. A lot will rest on what Nokia can conjure up and how interesting it can make its phones, which will be competing against devices from other Windows Phone makers.

Nokia’s CEO, Stephen Elop, said Nokia will bring its first WP7 devices to specific countries later this year before a systematic increase in markets and launch partners in 2012. That means that this coming quarter is also not likely to reflect a big showing in WP7 devices, or smartphones overall, unless Nokia creates an absolute home run that can move units in a big way despite a limited rollout in select countries.

The big test will be next year as it ramps up distribution of Windows Phones. But the pressure is on for Nokia to demonstrate that it made the right bet on Windows Phone and that it has some pretty stunning hardware to show for it. The handsets will need to be markedly better than anything it has in its stable, including the N9, a very compelling device that launched with Nokia and Intel’s MeeGo OS. Positive reviews of the N9 have prompted many to wonder why Nokia essentially discarded MeeGo in favor of Windows Phone 7, something Elop will have to answer by showing just how much Nokia can do with Microsoft’s platform.

I still have some reservations about Nokia and Windows Phone. There’s no guarantee that Nokia feature phone and existing smartphone users will automatically move up to a Nokia WP device just because of the brand name. The two companies will need to bring their A-game and show that any device they collaborate on can stand up to the iPhone 4S, with its new operating system and new Android 4.0–based devices. As we’ve noted, Mango is a big software update that puts Windows Phone in a great position to compete, but some of those improvements are starting to get lost in the frenzy around iOS 5 and Android Ice Cream Sandwich.

The stakes are extremely high for Nokia, which has bet the farm on Windows Phone. All eyes will be on the company next week, and it’s got a great shot at showing how far it has come in this rocky transition. But it’s going to have to rise to the challenge: The market is only accelerating toward smartphones, and Nokia knows it can’t bank on feature phones to bail it out in upcoming quarters.