The trouble with being number one in any industry is that you have nowhere to move but down. Few companies know this better than Nokia (NOK), the Finnish telecommunications giant that has dominated cell phones for so long that in some parts of the globe the brand itself has become synonymous with the device.

Nokia has long excelled at making beautiful phones, but in today’s competitive smartphone market, beauty is just a start. The devices that make consumers salivate are the ones that have great software, offer the most games and social networking features, get great service, and come attached to fast networks. Oh, and they have to be cheap.

One company has shaped this new competitive environment, and it’s not Nokia—nor was it even a telecommunications company until 2007 when it debuted the iPhone.

Apple (AAPL) is eating Nokia’s lunch.

With the iPhone, Apple created a consumer lust for smartphones by showing us we could browse the web from our palms and enjoy it. It launched a device so perfect in form that it has become the gold standard by which all other devices are measured. And it moved the global hub of telecommunications innovation from Asia, where form factors had previously trumped all else, to Silicon Valley, where software makers now race each other to come up with the coolest applications.

None of this has been good for Nokia, which had already lost substantial ground in the North American cell phone market (see “Nokia’s North America Problem”). Their struggle for market dominance in the age of the iPhone has been less about nailing an innovation strategy than playing a hardcore game of block and tackle.  Enter the latest move: on October 22, Nokia filed suit against Apple in a Delaware federal court claiming infringement on 10 patents it holds on the integration of several technologies at the heart of Apple’s iPhone.

As my colleague Philip Elmer-deWitt points out, you can’t blame Nokia for having its nose out of joint.  Apple, according to Nokia, has gotten a free ride since the iPhone launched—a very fast ride. Apple commands 22% of the smartphone market in the US, according to IDC. Globally, it holds 12% of the market, more than doubling its share from last year.

Meanwhile, despite its best efforts, Nokia has steadily lost ground. It holds 40% of the market, down from 43% last year, according to IDC. And in the competitive North American market, Nokia is barely holding its own with just 3%.

Recognizing that the North American market is more crucial than ever, Nokia has spent the last couple years retooling its strategy. It installed its chief financial officer in the U.S. It opened new offices in Atlanta to be close to AT&T Mobility (AT&T) and in Parsippany, N.J., to be near Verizon Wireless (VZ). And it put several hundred product developers in its San Diego design center to work in collaboration with AT&T and Verizon Wireless on some new products.

The efforts have begun to yield dividends as North American carriers have started to support a slew of new cell phones—and even a couple of smartphones—but progress is slow going. “We’ve not been good at delivering promises in the past,” Niklas Savander, who heads up Nokia’s services division, told me recently, in describing Nokia’s relationships with the carriers. “It’s a trust thing and it doesn’t go away easily.”

Savander said he's also stepping up the company’s efforts with its Ovi store by making strategic acquisitions, mostly as a way to hire new software development talent. In September, Nokia bought social networking company Plum Ventures and traveling startup Dopplr.

So far, these changes have not been enough to jumpstart Nokia’s smartphone growth. On October 15, the company reported a third-quarter loss of $836 million as sales fell 20% from a year earlier (in North America, sales dropped 25%). And as the Christmas season approaches, bringing a gaggle of gadgets for Santa to deliver, Nokia has a paltry smartphone offeri. It’s easy to understand why the telecommunications giant, explaining that it has sunk $60 billion into the research and development that has helped enable the devices to take off, might at least want Apple to share the wealth.

After the Vista debacle, Microsoft changed the way it makes software. The result – Windows 7 – is winning raves. Can a new operating system (and a new attitude) help the company take on Google?

With Microsoft's founder and chairman, Bill Gates, trotting the globe in a quest to abolish diseases, his handpicked successor, CEO Steve Ballmer, has had most of a decade to move the company beyond its two biggest cash cows, the Windows operating system and the Office productivity suite. So far, not so good.

The company's web forays, such as MSN, have only highlighted the dominance of Google and Yahoo. In software for smartphones, there is Apple, RIM (RIMM), and everybody else. MP3 players? Microsoft's Zune hardly merits a mention. And even the core franchise has suffered. In the face of slowing PC sales and the economic pall, Microsoft's fiscal 2009 revenue actually contracted, to $58.4 billion from more than $60 billion in fiscal 2008 — and the company missed its earnings estimate by more than $1 billion.

Fresh Coat of Paint: Artist Ricardo Richey, commissioned by Fortune, spray-paints a street-smartversion of Microsoft'sname and Window's logo on a San Francisco wall.

But the biggest failure under Ballmer's tenure was self-inflicted. Vista was meant to be a wholesale reimagining of Windows, the brand name for Microsoft's operating systems dating back to the early 1980s. Every so often the company unveils a new OS, blandly named for the year of the release (Windows 95, Windows 98) or a geeky abbreviation (Windows XP is short for Windows Experience). Vista had a marketing-friendly moniker, a fancy user interface, new security architecture, a better file-storage system, and much more.

After a protracted six-year development process, much internal squabbling, false starts, blown deadlines, and broken promises to partners, the engineering team mopped up 50 million lines of code, wrung it all out into a shrink-wrapped box, and heaved it onto the world in early 2007.

The timing couldn't have been worse. Vista required top-end hardware to operate even while users were downgrading from desktops to notebooks. The bloated OS was incompatible with printers, web cams, and device drivers of all sorts. Early adopters scurried back to Windows XP; many corporations skipped the upgrade altogether. Worst of all, Vista energized the cloud computing chorus, led by Google (GOOG), whose vision of the future involves ubiquitous broadband, a good web browser, and everything else hosted on the Internet. No sophisticated operating system necessary. "Vista was the biggest debacle in the history of the company," says one former senior executive. "People were ashamed to say they worked on it."

But here's some good news: On Oct. 22 Vista will be safely behind Microsoft (MSFT). On that day, the company will introduce a successor, Windows 7, and guess what? It doesn't suck. In fact, it's really pretty good. For all the pomp around each new version of the iPhone, the latest Kindle, or Google's next beta, Wave, Windows 7 is sure to go down as the technology launch of the year. Critics love it, and IT managers are ready to buy. A recent Credit Suisse survey says that a quarter of corporate customers plan to upgrade within two years. Analysts estimate that the new OS could boost Microsoft's revenue by more than $3 billion over that time and ignite the entire ecosystem built on Windows — from computer makers like Dell and Hewlett-Packard (HPQ) to third-party software vendors, resellers, and system supporters. It could be the shot in the arm the entire tech sector has been looking for.

On a warm September day in Redmond, Wash., sitting in a conference room in Building 34, the economic epicenter of the Northwest, Ballmer is not ready to declare the doldrums over. A stock market turnaround means little in the face of staggering unemployment. But he remains hopeful because he thinks this version of Windows is a winner. "It's a great product. We did our best. Is that going to cause huge increases in spending by the world's businesses? I can't make that promise," he says, "although I think things are becoming slightly less cautious. There's some hope that says, ‘Hey, look, maybe this is part of the turnaround.'"

Back from the abyss

It's just a hint of optimism from an executive who has been bearish on the economy of late, an indication that the mood is shifting at one of the most self-loathing, hypercritical corporate cultures you're ever likely to encounter. As bad as the Vista years have been, Microsoft seems to be getting its act together. The Wall Street collapse stunned the company, and management reacted with uncharacteristic alacrity. "There was a week or two where everything seemed to come to a stop," says CFO Chris Liddell, "and we said, 'We're going to have to operate in a different way.' "The company laid off 5,000 employees and instituted a "10-point plan" to cut wasteful spending, from vendor allotments to travel and entertainment.

Meanwhile, executives ramped up development cycles. This past summer the company kicked off, in its words, "a year of product launches unlike any other in Microsoft history." Since then, Ballmer et al. have revamped Windows Server and unveiled the Zune HD line of MP3 players. On the way: overhauls of Windows Mobile, Office, Internet Explorer, Xbox Live, Bing (its new search engine), and the introduction of Azure, a plunge into the enemy territory of cloud computing. Microsoft is also about to venture into retailing, an area conquered by longtime nemesis Apple (AAPL).

All this, says Bob Muglia, president of the server and tools division, is part of what he calls Microsoft v.3 — a play on the old saw that it takes the company three releases to get a product right. "In the Vista era, we lost track of a bunch of things," he says. "Now Windows 7 has shipped, and it's the official start of [a time of] mature leadership, competitive focus, aggressive competition — and I think you see the results. You could say it's us getting our mojo back."

If Steve Ballmer has one attribute of a great leader, it's an ability to inspire the troops — which is what he's about to do standing onstage in July at a convention center in downtown New Orleans. The Big Easy is broiling in a midsummer haze. The locals have cleared out, making way for the 5,000 Microsoft partners — resellers, builders, software developers — who have gathered at a conference organized in their honor. Ballmer is, naturally, the headline act. He's peeled off some pretty outlandish keynotes over the years, including "Steve Ballmer Going Crazy" (2 million views on You- Tube) — in which he huffs, "Come on, give it up for me!" — and the much-remixed "Developers" (1 million-plus views), where a heavier Ballmer performs a sweaty, arrhythmic stomp dance.

Today job one is to inject some optimism into the crowd. Ballmer had a tough year. He took a modest (for a man worth $11 billion) pay cut. But his small-business partners are reeling from the downturn. "This is the most phenomenal year we've ever had for technology releases," he rumbles, ticking off reasons to be hopeful about 2010. Microsoft vows to keep investing $9 billion-plus in R&D, it'll increase spending on partner support, and most of all it will keep fighting competitors — because, well, that's what the company does best. "We don't go home," he says. "We just keep coming and coming and coming. We're tenacious, tenacious, tenacious. Boom!"

That's not entirely true. Over the years the company has cowered at least a few times. It bailed on Microsoft Money (a personal finance product designed to oust Quicken), would-be YouTube killer Soapbox, the long-forgotten BOB operating system for kids, tablet PCs, web-enabled TVs, etc. But the company has surely disrupted many markets — from web browsers to console games — by offering a fresh perspective. "Novell said, ‘The world is about single purpose operating systems,' " explains Ballmer, back at Building 34."We had to say, ‘No, the world is really about multiple-purpose operating systems.' Lotus and WordPerfect said, ‘The world is character-based,' and we said, ‘No, let's try some graphics.' Apple said, ‘The world is a proprietary software-hardware combination,' and we said, ‘No, the world needs to be open to choice.'"

The enemy within

Such conquests, while dated, have earned the company a reputation for being obsessed with competitors — a characterization Ballmer does little to diminish. Unlike most executives of his ilk, he says what's on his mind, which can include calling Google a "house of cards" or referring to Linux as a "cancer that … attaches itself to everything it touches." He once laughed derisively on camera at the prospect of the iPhone ever succeeding. But in Microsoft's core business, there is no real competition. Various versions of Windows run more than 95% of all PCs. So when it came to preventing another Vista, Ballmer had to find the enemy within.

Windows 7 is a departure from Vista in many ways. It will be unveiled on time after a three-year development cycle. It's compatible with previous versions and has excised all the security-permissions protocols that were lampooned in Apple's "I'm a Mac" ad campaign. It's sharp-looking, almost as sleek as the Mac OS, and has a few cool new features, like support for multitouch monitors and Aero Shake, which allows users to clear the desktop with a jiggle of the mouse. Perhaps most impressively, it requires less computing horsepower than Vista. That just never happens with a new OS. But the biggest departure comes in scope and ambition. Ballmer claims to have learned something from Vista: It's no longer advisable to try a "big bang" rollout — i.e., completely reimagine a product as sophisticated and interconnected as Windows.

So he hit control-alt-delete. He brought in a new taskmaster, Steven Sinofsky, to oversee the engineering. Sinofsky became known for hitting deadlines while overseeing the Office group from 2000–07. An executive close to the Windows team characterizes his changes as such: "Reset — or reboot — is something that we hear a lot about the transition," he says. "What we did was [give] the development team a clarity that was probably missing." With Vista, teams worked on features simultaneously without an awareness of other schedules. When separate features came together, they were often incompatible. "The goal was to produce a plan for features, but not just a plan — also the motivation, the business rationale," the executive says.

Sinofsky oversaw the largest beta test in history — more than 8 million users — blogged tirelessly about every little tweak, and kept lines open with partners. The team scrubbed inefficiencies and ushered out a fully functional, backward-compatible OS on time, earning Sinofsky a promotion to president of the Windows division. The new openness has resonated in the marketplace. According to Credit Suisse, 58% of corporate customers were either dissatisfied or extremely dissatisfied with Vista. With Windows 7, it's 21% dissatisfied and none extremely dissatisfied. The PC makers seem happy too. "With Vista, the expectations were very high, and the customer reaction was not so positive," says Satjiv Chahil, senior VP of global marketing for HP's Personal Systems Group. "This time the response has been very positive. It's what the market has been waiting for." In the end Windows 7 is what Vista should have been the first time.

Software fades

With its house in order, Microsoft can safely get back to its imperialistic ways. And there's no bigger land grab than web search. Ballmer has pledged to fund his new search engine, Bing, with as much as 10% of operating income over the next five years (potentially $11 billion). Why do something so risky when he's lost so much online already? Because the opportunity is simply too big to ignore. Microsoft considers the global search market to be worth as much as $80 billion. And Ballmer recognizes that there's even more power than money in being the leader. Google.com is what Windows used to be: leverage. Controlling the on-ramp to the web allows a company to distribute a broad array of products, which is what Google does so effectively. "They promote YouTube, they promote Chrome," he says, referring to Google's web browser. "If it was us, people would call it an unfair advantage."

As the importance of client software diminishes, so too does Microsoft as we know it. Bing represents the company's best hope yet of maintaining its own unfair advantage. And Ballmer thinks that Google, despite its enormous market share, is vulnerable. "There are a lot of negative views right now of what's going on — Google Books, monopolization, blah, blah, blah," he says, simultaneously highlighting and waving away a growing anti- Google sentiment. "Put all that aside and you have to ask, ‘Has the experience really changed much? Is it easier to find what you're looking for? Is there a chance to do a better job?' I think there's a real opportunity to do that, and somebody had better seize it. Who's got the best shot?"

Microsoft launched Bing in May, and it confirms Muglia's assertion that the company has become more focused on customers. Rather than Google's minimalist homepage, Bing rotates stunning photos embedded with interesting snippets about various parts of the globe. Like Google, the site acts as a jumping-off point, but has just enough flair to make you want to linger. Visitors see more information than they do in Google results and can even play videos without clicking away. Bing is organized more intuitively, and it outperforms in real-time search — a big plus for the Twitter set.

Early returns have been promising. Before Bing, Microsoft's search engine, Live Search, had 8% of the market, according to ComScore. After three months Bing stands at 9.3%; meanwhile, Google's share has dropped 0.4%. Over the summer Microsoft struck a deal for Bing to power the search function across many Yahoo (YHOO) properties. Once the arrangement kicks in, Bing's share could jump to around 30%. "It's a pretty good start," says Yusuf Mehdi, SVP of Microsoft's online audience group. "Best of all, it's really hot with certain demographics, like elementary school children and women, because of the aesthetic design and feel."

Of course the hope is that greater traffic will lure advertisers. Craig Macdonald is the chief marketing officer at media-buying firm Covario. He spends $250 million a year on search ads for clients like McAfee, Intel (INTC), and Procter & Gamble. Impressed with Bing's aesthetic and buzz, he initially increased spending, but has been disappointed. "We saw a 15% to 20% increase in impressions but a 39% spike in the cost of acquisition," he says. Compared with Live Search traffic, driven primarily from the MSN homepage, Bing users are younger, more web-savvy, and frugal. "They did a nice job creating buzz, but we said, ‘We're pulling back.' "

Microsoft may yet benefit from the anti-Google sentiment that Ballmer calls out. No one likes a monopoly, and everyone's favorite web brand has become a freeloader in the eyes of the telecom, book, and media industries. Some of Google's partners have grown disenchanted as well. "With Google, everything's a black box, completely opaque. You have no idea why things go up or down. They're impossible to deal with," says the president of a website that each year generates more than $10 million hosting Google AdSense ads. "Everyone who's not Google is rooting for someone to be a counterweight."

It's not obvious from walking around the company's sprawling campus that Microsoft is locked in combat with some of the business world's most ferocious competitors. There's little resemblance here to the 24/7 sleep-under-the-desk startup culture that permeates Silicon Valley. Many executives are tanned and fit from weekend sails on Puget Sound, hiking up Mount Rainier, golfing, or exploring Machu Picchu. People arrive promptly to meetings, smile broadly, and are exceedingly polite. If quality of life were the most important metric for a recent grad deciding between Redmond and Redwood City, there really would be no choice.

The Valley set sees this as a sign of age and weakness. "They're the IBM of this generation," says Tod Nielsen, chief operating officer of virtualization software company VMware, who worked at Microsoft for 12 years and now competes with his former employer. "They're profitable and successful, but there's not a lot of excitement. It used to be the velvet sweatshop. Now it's all about 9 to 5, 10 to 5 if you're good, and 10 to 4 if you're really good."

Some ex-employees and analysts, none of whom spoke for attribution, agree that the company remains hugely inefficient and lacks vision. They also question whether Ballmer is up to the task of taking on Google, Apple, VMware, and so many other laser-focused competitors. "If shareholders could vote, I don't think they'd pick Steve," says a former vice president who claims to have left Microsoft on good terms. "It's the whole 'dances with elephants' thing, and I don't think Steve can be Gerstner," he adds, referring to Lou Gerstner's book "Who Says Elephants Can't Dance?", in which he details how he rescued IBM (IBM).

It's an easy analogy — the old IBM and the current Microsoft both bulked up in a bygone era. But pre-Gerstner, IBM was on the brink. Its finance team held weekly meetings to see whether the company could cover payroll. With $15 billion in annual net income, Microsoft, on the other hand, is a cash machine. Even the great Vista failure must be viewed with perspective: It runs 350 million PCs. Analysts expect the Windows division to turn an $11 billion profit in fiscal 2010. And really, that's Ballmer's unfair advantage. The profits rolling off Windows and Office subsidize any lack of vision and allow the company to go the safer, more expensive route of chasing down Goliaths after new markets have solidified.

In search, Microsoft is confronting a Goliath with arguably as much market power. (Google has a $158 billion market cap, vs. Microsoft's $230 billion.) Google's new Chrome browser could prove a significant threat to Internet Explorer, which has already been encroached upon by Mozilla's Firefox. Gmail is making headway with businesses in the battle against Exchange, not to mention consumers. Google Docs has spurred Microsoft to make parts of Office available online free in coming months. And then there's Google's Android OS for mobile phones. Launched in 2007, Android will operate more than two dozen heavily hyped phones by 2010, including T-Mobile's MyTouch.

The battle between these two titans isn't just about bragging rights or short-term profit. As our computing activity moves increasingly off our PCs into our phones, onto the web, and all around us, the most platform-agnostic company will rule. That presents Microsoft with a classic innovator's dilemma: It must diminish, or at least ignore, its prior success to secure a place in the future.

Which is why Google executives like their position in this fight. "They are a very large incumbent in an area that's shifting toward a new technology — cloud computing," says Dave Girouard, president of enterprise for Google. "We are a company that was born of the cloud, and we don't have to deal with the legacy issues they have to deal with."

A year ago it would have been easy to agree with Girouard and skeptics who dismiss Microsoft as a sluggish incumbent. But the Windows 7 reboot has reinvigorated the company. In November it will launch Azure, a platform for building applications that are delivered via the Internet; as with Windows 7, potential users seem optimistic. For a change, Microsoft is even getting under Google's skin: Google's Chrome OS basically looks like a PR ploy designed to drive Ballmer nuts.

Whether the company circa 2009 truly represents Microsoft v.3, as Muglia suggests — the version in which Redmond gets things right — Vista is a turning point. It will be remembered either as a harbinger of a bloated company in decline, or it will be the wake-up call that prompted Ballmer and his team to set down a new path. Of course it will be years before we know how the Microsoft story, post-Vista, will play out. As Ballmer himself will tell you, "Plenty of people say everything in tech takes off or fails quickly. There's nothing more laughable than that."

–Reporter Associate, Kim Thai

Box.net CEO Aaron Levie. Photo: Box.net.

Cost-conscious businesses are looking online for IT

By Aaron Levie, CEO and co-founder, Box.net

Something is clearly happening in the cloud. Two major juggernauts – the government and Microsoft – have both recently made cloud-related announcements. The government (hardly ever considered an early adopter) is planning to launch a cloud computing ‘Storefront’ to ease the federal deployment of these online services, with the ultimate goal of streamlining operations and saving money. Microsoft has finally detailed its plans to launch a web-based version of Office, albeit not until next year.

Check the press, and article after article mentions this trend: IT departments are increasingly relying on web-based shared computing and storage, rather than owning and managing the hardware and software themselves. What is pushing this forward? Let's take a look.

It starts with the bottom line. In a recession, every business wants to reduce its cost of operations. A quick review of the total cost of ownership for traditional technology includes IT personnel, data centers, servers, support licenses, and professional services – and that’s before you add in the actual cost of the software. The current economic crisis is causing businesses of all sizes and competencies to rethink where they want to invest their human and financial capital, and in most cases it's not in managing a costly IT infrastructure.

The key advantage of web-based solution providers is that they tap into true economies of scale by shouldering the infrastructure burden themselves, running technology efficiently, and passing the savings to their customers. For example, Salesforce.com manages thousands of companies' backend sales systems and requires far fewer resources than if all its customers were to host the solution themselves.

Another driver of the cloud trend is an increasingly mobile, global workforce. The culture of business has changed as laptops, wifi and web-connected cell phones have introduced more opportunities for unique work-life balance. As teams become increasingly distributed, technology must continue to empower efficiency even while spread across multiple time zones and languages.

Cloud-based services are in the best position to enable workers to stay connected at all times on day one. Whether it's through messaging, conferencing, collaboration or customer relations, businesses on varying networks can now seamlessly interact as if they were in the same building.

Of course, there are problems that threaten to slow the adoption of cloud services. At the top of the list are security and data portability.

As we saw with the Twitter-hacking fiasco, cloud solutions are only as strong as your password, and combining this with the weaker data management policies of consumer-focused web services can cause a nightmare scenario. Unlike the on-premise model of virtual private networks and tighter application privileges and permissions, users can generally register and access cloud services with a single password and email address (which is often considered a big benefit as it's easy to get started). However, these flexibilities create problems of unwieldy proportions for an IT person tasked with making sure users' data are safe and secure. To solve this, we need more centrally managed authentication systems (think LDAP for the web), application providers to provide highly-secure authentication practices on their own, and deep visibility and control into who and when information is accessed.

In addition, cloud services often lack complete data portability. Yes, there are many useful APIs that allow us to mash up various services together, but there's a clear absence of simple and obvious ways for applications to communicate uniformly and move data back and forth. When companies can securely and seamlessly move their cloud file system from one provider to another, or between email applications, or even just share data between two online word processors, we'll start to see full enterprise cloud adoption.

The good news is that fixes for these (and other) issues aren’t far off. Businesses have been building their own solutions, startups are popping up to offer better security, and many cloud companies are building this additional layer of protection themselves. The timer has been set, and it won’t be long until the whole concept of the ‘cloud’ will become dated as people will wonder how they ever did without it.

Aaron Levie is the CEO and co-founder of Box.net, a Palo Alto, CA-based provider of online collaboration tools.

Randall Stephenson’s business is all about connectivity, which means these days the AT&T chairman and CEO spends a lot of time talking about Apple.

While the company may have an exclusive deal with the maker of the iPhone, Stephenson said don’t expect it to last forever, although he wouldn’t expand further.

When asked if he was completely satisfied with AT&T’s relationship with Apple, Stephenson said, “I don’t think I could get my wife to say that about me so I don’t think I could say that about a business partner.”

While he thinks that on balance the relationship with Apple works well, there are some areas he’d like to “tweak,” such as the expense of the handset. “You subsidize these handsets with the expectation you’re going to get a high-end customer,” he said, speaking on the back of quarterly results, released this morning.

Responding to an audience question, he did acknowledge that the company is having network issues in some markets, centered around were iPhone penetration is highest.

“It’s a big deal,” he said. “All of us rely on these services for our day-to-day activity,” adding that “you’re only going to win in this business if your network quality is the best.”

But Stephenson said no one is experiencing the same volume levels as AT&T, and the company is spending billions of dollars to address these problems.

Stephenson also revealed that he’s a big fan of the Kindle. “I bought one of the first devices out and fell in love with it,” he said. While the Kindle may or may not be the one that got away for AT&T, the company has partnered with e-reader maker Plastic Logic to capitalize on what Stephenson thinks are going to be very important devices in the future.

Mobile platforms VP Andy Rubin talks about Android, Chrome, and the smartphone.

The second Google (GOOG) phone in the U.S. had a showcase event last week in San Francisco, and afterward I sat down with Andy Rubin, vice president of mobile platforms at Google.

Rubin believes Google helps consumers

I asked him about Google’s vision for the Android smartphone operating system, whether the search giant is sending mixed messages by promoting both Android and its upcoming Chrome OS, and whether Android is really a good fit for netbooks. Below is an edited transcript:

Q. Android is open and free, so anyone can put it in their devices – phones, cars, washing machines, whatever. But what uses is Google actively encouraging? Are you just focused on smartphones, or are you trying to get it on other types of devices?

A. This is kind of where open source meets business. I encourage high-volume things. A million customers? Not that interesting. Ten million? Not that interesting, but heading in the right direction. A hundred million customers starts getting interesting. So what consumer products have the opportunity to affect 100 million, 200 million, 300 million customers? There aren’t that many. What’s the most successful consumer product on the planet? People used to say the DVD. It’s the cell phone. They’re everywhere. That’s why we focused on the cell phone first – it’s the biggest volume opportunity.

Q. What other high-volume opportunities are there for Android?

A. Use your imagination. Whatever it is – it might not be something I know about today – but if it’s high volume, I’m on it.

Q. iPods are pretty high volume.

A. The iPod’s a media player and that’s a pretty high-volume consumer product. The problem with iPods, when it comes to the Internet, is that they’re not connected devices, they’re media players. And so it doesn’t move forward our desire to see a lot of consumers connected to the Internet, getting access to information and having it organized in relevant, interesting ways.

Q. Now we’ve got Pandora and other Internet radio offerings on media players though, and they seem to be taking off in popularity precisely because they’re connected. Does that change your outlook?

A. What I hope it will change is hardware manufacturers’ perspective on what features they build into their products. You’ll see more and more connected media players, media players with WiFi built into them. I think that will become an enabler from a chicken and egg perspective, of having Android in a lot of those devices.

Q. It seems netbooks could be a high-volume device, but we’ve got two messages coming from Google at the moment – Chrome OS and Android. So what do you with Android and netbooks do – do you encourage that, or are you waiting for Chrome OS to come out?

A. I certainly don’t discourage it, right? Why would I want to do that? It’s providing as many consumer products as possible with access to the Internet. I don’t care if they use Chrome, I don’t care if they use Android. As long as we’re giving people access, the engine that is Google can do its job. We’re trying to get more people on the Internet so they’re enabled to use Google services. Honestly, it’s not a religious thing. I don’t care how we do it ,as long as we do it. I truly, deeply believe that we’re helping consumers.

Q. I get the sense that you personally care about Android and its success because your work on it predates your employment with Google. But does Google really care about Android itself, or is it a means to an end – getting more people onto the Internet so they can use Google search and other products and generate revenue by doing commerce through Google? Isn’t Google just as happy about an iPhone or a Palm Pre as it would be about an Android device?

A. I think when we introduced Android, the most telling answer to that question was when [Google co-founder] Sergey Brin did a video. And he basically said, when I was a college student and Larry and I invented Google, we based it off of open source. We used Linux. And he said he feels morally that he wants to give back to the open source community because it was something that enabled Google. So he believes, obviously, in running the business. But he also believes that the business wouldn’t have even existed if it weren’t for this type of technology. So what other businesses can you create on this type of technology? And it changes Google’s role into more of a mentorship role in helping those other businesses get off the ground. I think it’s a very, very broad view, different from your traditional CFO, who’s just focused on bottom line and incrementally doing stuff. It’s not an incremental vision. It’s a many-year, long-term vision. And the fact that the guys inside this company understand that is one of the reasons Google is successful today, and will continue to be successful. And by the way, that’s the reason I agreed to come work with Google. It’s that type of leadership that, for me as an entrepreneur, it enables every one of my visions. I don’t feel blocked at all.

A sign of things to come? In its Atlanta stores, AT&T is selling the Acer Aspire One for $49 with a 2-year wireless data plan and DSL signup. Image: Acer

PC retail is in rough shape again, and it's about to get rougher.

Evidence of hardship is everywhere. Hewett-Packard (HPQ), the world's largest computer maker, says it's selling about the same number of computers as a year ago, but getting a lot less money for them – sales dropped 19% in the most recent quarter. When Apple (AAPL) reports earnings in July, analysts expect Mac sales to be off as well. And while Intel (INTC) says it's hopeful that its chip sales are bottoming out, chip revenues are lower than they have been in years.

Why are things so bad? The easy answer is that PCs cost hundreds of dollars, and consumers don't have a lot of extra cash floating around these days. Unless your computer has been struck by lightning and given up the ghost, chances are you're holding off on purchasing a new one. One tech industry executive recently confided to me that it's not just U.S. consumers thinking this way – the entire global PC market headed off a cliff at roughly the same time late last year, forcing computer makers to cut workers and rethink their strategies.

In the midst of all that, wireless carriers are poised to shake up PC retail. AT&T (T) announced this week that beginning this summer, it will begin selling small, low-cost Windows XP netbooks from Acer, Dell (DELL), LG and Lenovo in all 2,200 of its U.S. stores. (In case you're counting, that's about twice as many locations as Best Buy (BBY) has.) Rival Verizon (VZ) has already begun selling an HP netbook.

Why buy a computer from a phone company? Price, of course. Sign a two-year wireless data contract with AT&T, for example, and you get $50 knocked off the price of a netbook. Get home DSL service too and save $100. In Atlanta, where AT&T has been testing the deals, the cheapest Acer netbook sells for $49 after rebates.

Sales there have been brisk enough that AT&T execs are confident that cheap laptops will lure customers nationwide the same way cheap phones have in the past. And the deals will only get better: It's easy to imagine that in a year or two, customers who sign up for two years of voice and data service (at a cost north of $100 per month) will leave a store with both a "free" phone and a "free" computer. Exciting, huh?

While this is great news for netbook-loving consumers, it's a downright scary prospect for PC makers. If the phone business is any guide, carriers will fuel demand for the cheapest and least profitable computers out there, and put pressure on traditional PC stores to sell low-price PCs. And that will force tech companies to work harder to lure shoppers toward more powerful (and more expensive) hardware.

That's not an impossible upsell, as the iPhone and BlackBerry (RIMM) have proven in the phone business. But it's yet another challenge the PC gang doesn't exactly need right now.

Cisco CIO Rebecca Jacoby

Even in these tough economic times, tech giant Cisco offers employees some pretty sweet benefits: Employees can visit on-campus doctors and dietitians, drop off dry cleaning, or get an oil change, and now they can pick the kind of computer they want to use at work.

That's right – Cisco has started letting workers choose from a handful of laptops, including an Apple MacBook Pro. Only don't call the program a perquisite. Rebecca Jacoby, Cisco's (CSCO, Fortune 500) top information technology officer, says the initiative, launched last year, should actually save the company money. The fact that employees involved in the pilot program are deliriously happy with it – Jacoby and her peers even get love notes from satisfied road warriors – is a bonus.

Of course, that new freedom requires companies and employees alike to make sacrifices. Since Cisco began offering a choice of machines last June, roughly a quarter of employees have opted for Macs, yet they are pretty much on their own for tech support. (An in-house online community for Mac users gets a little help from Jacoby's department.) Cisco, in turn, has to make a slightly higher upfront investment for the workers who want Macs, which are pricier than PCs.

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Jon Fortt recaps Apple's preview of the next-generation iPhone OS, due this summer. (AAPL) (RIMM) (T) (PALM) (MOT) (NOK) (MSFT)

Since Intel first began cooking up semiconductors, it has taken great pride in its in-house manufacturing chops. If a chip carried the Intel brand, you could be sure it was created in an Intel fab.

Today the pride is the same, but the methods are changing. The Silicon Valley chipmaker on Monday announced a deal that will allow Taiwanese contract manufacturer TSMC to make custom versions of the Atom chip, the first time it's giving another company access to some of its chip cores. How big a deal is this? It's a little like George Lucas agreeing to let someone else make Star Wars movies. (Judging by the most recent ones, that might not be such a bad idea.)

It's not a decision Intel (INTC) came to lightly. For years, companies like TSMC (TSM) have begged Intel for the chance to make chips based on cutting-edge Intel architecture – and Intel has told them to get lost. It was obvious why other chip companies longed to build Intel chips; they serve as the brains of roughly 80% of the world's computers, and oh yeah, they pull in a tidy profit in the process. But why would Intel ever share its secret sauce? By doing everything in-house, the company has grown into one of just a few mega-brands in tech.

In today's environment, though, Intel needs TSMC. What for? In case you haven't noticed, the PC business isn't what it used to be. Technology research firm Gartner predicts that the industry will have its worst year ever, with worldwide shipments dropping 12%. (Until now, the worst decline on record was a 3% dip in 2001.) To keep growing, Intel needs to expand into new markets. Largely, that means mobile: Everything that has a screen and uses battery power is a potential candidate to get Intel inside, including the GPS device in your car, the iPhone in your pocket, and the Nintendo DS in your kid's backpack.

To get that new mobile business, however, Intel knows it has to change some things – including the way it makes chips. Here's why: When it comes to mobile devices, the Nintendos (NTDOF) and Apples (AAPL) of the world don't play by the old PC rules. Instead, they use customizable chip designs from a company called ARM (ARMH).

It turns out, customization and flexibility is a big deal in the mobile world. Intel's chip manufacturing may be the most advanced in the world, but many mobile customers would rather use a chip architecture that lets them tweak the capabilities. (That's why Apple last year bought chip design shop PA Semi for a reported $278 million; word is the engineers are working on custom chip designs for future iPhones and iPods.)

Which brings us back to Monday's announcement. It just so happens that many companies get their custom ARM-based designs manufactured by – you guessed it – TSMC. So by allowing TSMC to make some Atom chips, Intel's sending the message that to be a player in the mobile market, it's prepared to play by the mobile rules, and give customers more flexibility than it ever has before.

This doesn't mean Intel is backing away from its role as a manufacturer. Intel will continue to make chips itself – it recently announced plans to spend $7 billion to enhance its own manufacturing capabilities – and it will place strict limits on how TSMC can use its Atom cores. Any customer who wants to customize Atom will still have to deal with Intel. This deal with TSMC adds a new flexibility to Intel's model, and in the process, Intel also gets access to TSMC's processes, intellectual property, libraries and design flows – the ingredients that let customers tweak their chips.

Could Intel have offered that flexibility without TSMC's help? Not anytime soon. In a way, TSMC is the perfect partner for Intel's needs. Because it's a foundry that makes chips for a legion of customers, TSMC is like a short-order chef set up to make custom meals. Intel, on the other hand, is like a gourmet chef set up specifically to whip up his own menu.

It will be a while before we see whether these two chefs can work well together. Both companies said they're eager for TSMC to start serving up Atom chips, but there are still a lot of business and product details to work out.

And then there are the cultural issues that are sure to arise. Just think: All its life, Intel's been top chef in its own restaurant. It may find that working with a partner feels like too many cooks in the kitchen. (INTC) (AMD) (TSM) (AAPL) (QCOM) (NOK) (MOT) (NVDA)

The world's two largest creators of computer chips are cooking something up together.

On Monday morning, there will be a chip industry summit of sorts: Intel, the world's largest chipmaker, and Taiwan Semiconductor Manufacturing Company, the world's largest chip foundry, will make a strategic announcement at Intel headquarters in Santa Clara. According to Intel (INTC) PR, the execs on hand will be Intel mobility chief Anand Chandrashekar and sales chief Sean Maloney, and TSMC (TSM) CEO Rick Tsai and sales chief Jason Chen.

What are they up to?

They're not saying – but it's not unusual for the two to cooperate. They've been known to work together on setting industry manufacturing standards. Two years ago they announced that TSMC would make WiMax chips for Intel. Intel has also been known to outsource the production of some chipsets and other items that don't require the very latest manufacturing processes. (The companies share more than WiMax chips; Chen ran sales for Intel before he joined TSMC four years ago.)

They're also competitors. TSMC makes chips for a bevy of Intel competitors including Nvidia (NVDA) and Qualcomm (QCOM).

Given that Chandrashekar and Maloney are attending for Intel, I'm guessing this announcement might focus on mobile and WiMax-type efforts. But considering the tough times in the chip industry – Gartner yesterday said it expects chip sales to plummet by up to a third in 2009 – lots of things could be on the table.

Whatever the deal is, it's probably something TSMC needs more desperately than Intel does. With its smaller chip customers swooning, one has to imagine Tsai might cut Intel a pretty sweet deal to get any business the chip giant would like to send his way. (NVDA) (AMD) (QCOM) (AAPL) (IBM)