Microsoft Corp. (NasdaqGS: MSFT) and Barnes & Noble (NYSE: BKS) dominated the headlines yesterday with their announcement that they are teaming up to grow Barnes and Noble’s e-book business.

Under the deal, Microsoft Corp. will invest in a new subsidiary of Barnes & Noble (called Newco for now). This business will consist of Barnes & Noble’s Nook e-reader and college textbook operations. As part of the agreement, Microsoft has also agreed to drop a number of patent infringement lawsuits relating to the Nook.

Microsoft Corp. is paying Barnes & Noble $300 million for 17.6% of Newco. That values the subsidiary at around $1.7 billion, or roughly double Barnes & Noble’s current market cap, further fueling speculation that the company will spin off this new business from its struggling bricks-and-mortar stores.

The news—including the possibility of a spin-off—sent Barnes & Noble stock soaring 51.7% on the day, though there were other factors influencing that rise, as well. More on that in a moment. Microsoft rose just 0.11%, to close at $32.02.

New Deal Instantly Gives Microsoft Corp. a Strong Presence in e-Books

The timing of the deal was auspicious, given the expected launch of Microsoft’s new Windows 8 operating system later this year. As part of the agreement, the companies said they will develop a Nook app that will come preinstalled with the new operating system.

That adds a wide range of new content to both the operating system and the company’s new Windows 8 tablets, due out this fall. The move may also give Microsoft Corp. the opportunity to sell its tablets in Barnes & Noble’s stores, though that wasn’t specifically addressed yesterday.

The e-book market itself continues to be hotly competitive. Right now, Amazon.com’s (NasdaqGS: AMZN) Kindle device is the leader, and the Nook is in second place, with about 25% of the market. The Nook currently uses Google’s (NasdaqGS: GOOG) Android operating system, but yesterday’s announcement had some wondering if that might change.  

Citigroup analyst Walter Pritchard certainly thinks so. In a note quoted on MarketWatch.com, he wrote that he sees Windows 8 becoming the operating system for the Nook in as little as 12 to 18 months.

He based his argument on the fact that the Nook uses a chipset designed by ARM Holdings and built by Texas Instruments, a chipmaker that Microsoft Corp. has already said will be one of its partners on its new tablets. Wrote Pritchard:

“As the various flavors of Windows are unified in the Windows 8 generation, having this broad array of devices becomes more important as it enables content owners and application developers to reach the largest possible number of end users.”

Pritchard has a buy rating and a $35 price target on Microsoft shares.

Latest Move by Microsoft Corp. Looks Like 1997 All Over Again—Almost

Meanwhile at Forbes.com, writer Peter Cohan drew an interesting comparison between yesterday’s announcement and Microsoft’s $150-million investment in Apple (NasdaqGS: AAPL) in 1997.

Back then, writes Cohan, Apple was struggling, as Barnes & Noble is now. And that deal, too, involved the settlement of patent issues, in that case litigation started by Apple against Microsoft. Apple’s shares also soared on the news. In the end, of course, the company went on to put on one of the most impressive turnarounds in U.S. corporate history.

But Cohan doesn’t think such a recovery is in the cards for Barnes & Noble. Why? Because the company continues to lose money, and it is burning through its cash at such a rate that it risks running out within the year. In addition, he writes, “The missing ingredient at Barnes & Noble is the business genius of Steve Jobs.”

Big Share Price Jump Has Short Sellers “Licking Their Wounds”

As mentioned, Barnes & Noble’s share price rose sharply following the announcement. But there was more to the story than just investor enthusiasm for the deal. Playing a larger role was the fact that a huge number of the company’s shares—roughly 19 million—that had been sold short before the announcement. As the share price rose following the news, many of those investors raced to sell back their shares to cover their losses, pushing the stock even higher.

That’s likely to continue for the coming days, as Reuters.com blogger Felix Salmon pointed out:

“All those shorts have lost a fortune today, and they’re going to have to cover sooner rather than later, driving the price up artificially. So at least for the next few days, it’s probably worth taking any market valuation for Barnes & Noble with a bit of a pinch of salt: technical factors are likely to overwhelm fundamentals until the shorts have retreated, licking their wounds.”