By Jon Fortt
November 30, 2006

All eyes are on Microsoft (MSFT) this week as it launches Windows Vista, the latest version of the software that powers the world’s PCs. As I watch from Silicon Valley though, I can’t shake the feeling that this could be the last time a Windows release feels like a big deal.

That’s because the most exciting tech advances these days aren’t happening on Microsoft’s Windows desktop. Instead, they’re happening online with services like Google (GOOG) Docs & Spreadsheets, YouTube video and MySpace social networking, and in our pockets with devices like the iTunes-connected iPod music player and the smartphone.

What does that mean for Microsoft? It means the hype surrounding Vista could be the titan’s last big chance to cast itself as the innovator of the future. Right now it seems the age of Microsoft’s Windows-fueled domination is fading, while a newly business-savvy Silicon Valley is making inroads.

Apple Computer (AAPL), humbled in the first round of the personal computing wars when its go-it-alone strategy doomed the premium-priced Mac to also-ran status, is playing it smarter this time with the iPod. Sure, Apple maintains tight control over its music empire – it refuses to allow songs from rival music stores onto the iPod, or let songs purchased through iTunes onto rival players. But it is proving savvy in other ways. Apple made the key decision early on to make the iPod compatible with Windows, negotiated important distribution deals with record companies, and continues to aggressively drive down the price of iPods by inking pivotal component deals with the likes of Samsung. More than any other factor, Apple’s attention to price and partnerships is making it difficult for competitors to offer consumers a well-designed iPod alternative. (Microsoft’s Zune isn’t impressing many people.)

Meanwhile Google is taking pages from Microsoft’s own playbook as it attempts to steal the software giant’s thunder. Google’s dominant position in search and online advertising has allowed it to build both a rich stock valuation that’s useful for buying companies, and an online advertising ecosystem that justifies spending more on YouTube than Microsoft was willing to pay. Google is also developing a suite of free Web-based software that performs the same basic functions as Microsoft Word and Excel, while allowing people to conveniently share their work with others. Google’s tactic – using its dominant online position to fold in services and undercut competitors – is reminiscent of Microsoft’s Web browser moves a decade ago. The difference this time is that Google is a free service that people can leave at any time, so unlike Microsoft, it’s unlikely to draw legal fire from the Justice Department.

So what’s Microsoft to do?

Vista alone won’t improve its fortunes much in the long term, though it’s certain to provide an enviable boost to earnings over the next couple of years. To deal with Apple, Microsoft must offer a media device that outperforms the iPod and links seamlessly to a software control panel – the Zune isn’t it. To best Google, Microsoft might have to consider releasing free versions of its Word and Excel software, sacrificing profit to keep a competitor from eating into its customer base. So far, Microsoft is avoiding that route – its Office Live strategy includes charging a monthly fee for online document creation and collaboration.

But all those worries are for later. This week belongs to Vista. Microsoft had best enjoy the party now – because next week the battle continues.

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