Microsoft is at a crucial point in its expanding efforts in the consumer arena. Company chairman and chief software architect Bill Gates used his keynote address at the International Consumer Electronics Show (CES) to unveil the Windows Home Server and announce that major service providers like AT&T would offer the Xbox 360 as a set-top box alternative. These announcements follow the launch of the Zune MP3 player and come right before the late January release of the retail version of Vista.

A few hours before his keynote speech, Gates took time to discuss the evolution of what the company calls connected entertainment with IDGNS -- Digit's sister news service. He also talked about the future of product distribution over the Web, how far Microsoft will go in hardware, and -- as he enters his last 18 months at Microsoft full time -- lessons he's learned as a technology visionary. An edited transcript of the interview follows:

IDGNS: You've been working on IPTV (Internet Protocol Television) for some time now and with the announcement that service providers will be offering the Xbox essentially as a set-top box alternative, it seems things are coming together. Can you talk about how this came about -- what happened on the technical side and what happened on the business side to make this deal come to fruition?

Gates: Obviously the success of the 360 -- in terms of getting the very best games that use high definition and getting people online so they could find their friends, do contests, be spectators -- that's become a key part of advanced gaming. In parallel with the Xbox 360 being developed, people like AT&T and others bet their company on having a state-of-the-art video offering and we became the partner to provide the software platform for that. And so they spent 2006 getting it put together.

Now in the next two years they're really gonna drive the numbers in a very big way. The idea of having as one of their offerings the ability to connect up to Xbox we think will be very attractive. In some ways you can think of this as a convergence device; it lets you project any PC in the home through the extender up into the living room. It lets you download high definition videos. It lets you play video games and now with IPTV it gives you the state-of-the-art TV viewing experience.

So all those things you want in the living room really don't require five remote controls and different user interfaces. Obviously as we drive the price down because of the incredible volumes there, that will allow this, as a set-top box, to not be a super premium price and yet have way more capabilities than the term set-top box has ever called to mind.

IDGNS: You used the term convergence. How does the Home Server fit into your vision of the connected entertainment home? Is there a scenario where a home might have a Home Server, an Xbox, a Media Center PC and a Zune? How do they work together?

Gates: Whenever you have multiple devices including multiple PCs that you want to share information with it's always been a bit complicated. Do you leave those PCs on and do connections PC-to-PC? We need something that you just plug in, is very simple and not only allows access within the home but remotely, and so that's what we've been working on. We've got some good partners. HP is a lead partner on this. We've made it awfully simple and we think in a multiple PC household this could be quite popular.

IDGNS: In an era when more and more people are downloading software over the Web do you think that Vista and the latest Office release will be the last of the sort of old school, big-bang product releases? Do you see, in the future, major upgrades available as a series of downloadable upgrades?

Gates: Well you can download Windows Vista as an upgrade; you can download Office as an upgrade. Those are things that we've enabled. A lot of the core features are available to you on an ongoing basis because you're connected up.

We will, every three years or so, have big upgrades to Office and Windows. Because when you want to change the scheduler, when you want to add vision, when you want to add speech, when you want to make it so that it can discover all the devices like screens as you go by or connect up to your Palm -- to test the compatibility and get the developers enthused about that, will fit the major release paradigm. (But) a lot of the layers we can rev in a very agile way. We've seen some of that now. With the base investment we've made with Vista, we'll be a lot more agile on those upper layer elements.

IDGNS: For years Microsoft executives including yourself seemed to want to avoid the hardware business. Now over the years that's been changing. You have Zune of course, and Xbox -- do you foresee a time when you get into other areas in terms of designing and building a product, albeit through contract manufacturers, on both the software and the hardware side?

Gates: Well the design side has always been a collaboration between us and the PC makers -- I see that with the HP touch screen device that they did with our Vista team or this new Sony Media Center, this really hot Toshiba portable that you don't have to connect up to dock. We do prototypes, you see that on the phones with the close relationships we have with the phone manufacturers.

I don't see any other form factors where we need to do hardware. I could be surprised on that. You know, we've seen some categories that have fairly special economics -- the subsidized video game and then the pre-eminent position Apple got into in the music players, and now us coming and saying, hey, we can provide something that's even better.

IDGNS: You don't want to get into the phone business for example?

Gates: No, no, no -- we love the variety and the innovation that our partners bring in to that phone space. Look at the different ways you're gonna have mapping and wallet and media, and the different input and screen sizes. It's great that Windows Mobile is going to be out on hundreds of form factors -- no single company could provide that.

IDGNS: Going to the new UI (user interface) in Office was a bit of a risk. What are the new risks that are keeping you up at nights these days?

Gates: Well the fun of being in this business is that it's always changing so you need to make bets. We made the IPTV bet a long time ago and that's just starting to pay off. We made the Xbox bet and people are just starting to see we're in a very strong position there. The Tablet bet, you know, people don't quite see that yet. Media Center -- some do, some don't. Some of the more advanced things that are still in research -- vision, speech -- I believe will be mainstream. We put massive amounts into those and they'll come into the typical experience that you have with the PC.

New ways of programming for parallel computing: That's a very important thing for us as these new chips have so many cores in them, and Microsoft has the right pieces -- the right operating system, the right applications, the right development tools to show people how to write that next generation of applications. So you know, we gotta make sure we're hiring the best people and we've always had incredible competitors like we do today. It keeps this business a lot of fun.

IDGNS: You mention the Tablet PC, it seems that's been dear to your heart over the years ...

Gates: Absolutely.

IDGNS: .... and WinFS. As you transition to more of a part-timer in the years ahead are there any aspects of the Microsoft business that you'll want to keep closer tabs on than others, projects that you're particularly interested in?

Gates: Well as I in mid-2008 stop being full-time, the overall technical oversight of the overall strategy, Ray Ozzie together with Craig Mundie pick that up so they'll have that. Those two together with Steve Ballmer will decide what projects they want to pick for my part time work and focus it on. There's a good chance they'll pick some things I've always believed in and shown passion for and that even 18 months from now might not be done so sure, Tablet I think is a good candidate for that list. And Steve's excited about some work I'm doing and some other new areas as well.

IDGNS: As you plunge more and more into philanthropy, looking back at your legacy in technology and the lessons you've learned as a business leader, what big lesson have you learned that's really informed your work in philanthropy, what are you taking away from the world of business that's shaping how you approach philanthropy?

Gates: Well the original optimism that I had when Microsoft got started -- that if you got a bunch of smart people together, gave them a clear mission, a bit of resources, they can do unbelievable things -- that I think is one of the most powerful things I take into tough challenges like vaccines for AIDS or malaria. How do we find these great people who come from different locations, how do we get behind them, how do we look at what those risks are, make that a very high bandwidth, very high morale type process? Some people, when they see tough problems, they think wow, is that solvable? My coming in with my optimism and resources often can, I hope, drive those things forward. That's certainly been a magic formula for Microsoft. I hope it works in those tough areas as well.