How to: Integrate the Installation of Team Foundation Server and Service Pack 1

Here it is, straight from TFS documentation:

This topic describes how to merge files from the installation DVD for Visual Studio Team System 2008 Team Foundation Server with the installation files for Service Pack 1 (SP1) so that you can install them at the same time. For more information, see Installing Team Foundation Server and Service Pack 1.

Note:
SP1 for Team System 2008 Team Foundation Server updates the server components of Team Foundation. If you install this service pack, you should also install SP1 for Visual Studio 2008 from the Microsoft Web site. This service pack updates Team Explorer and other clients of Team Foundation to work with Team Foundation Server SP1.

You can integrate the installation of SP1 with Team Foundation Server Trial Edition, Team Foundation Server Workgroup Edition, or an edition from a volume-licensing program. However, you must provide your product key, which you can find on your installation DVD. If you open the setup.sdb file in a text editor, you can search for a line that contains the text Product Key. The next line contains the product key. For more information, see this topic on the Microsoft Web site: How to: Locate the Product Key for Team Foundation Server. 

Required Permissions

To perform this procedure, you must be a member of the Administrators security group on the local computer.

To integrate the installation of Team Foundation Server and Service Pack 1
Download SP1 from the Microsoft Web site, and save the update to a folder on the local computer.

For example, you can save the file to C:\SP1Download.

From the files that originated on the DVD for Team Foundation Server, copy the AT folder to a location on the local computer.

For example, you can copy the folder to C:\InstallMedia.

Open a Command Prompt window, and type the following command, replacing C:\SP1Download with the location that you chose in step 1 and C:\SP1Extract with a separate location on the local computer:

C:\SP1Download\TFS90SP1-KB949786-ENU /extract:C:\SP1Extract

Create a folder where you can merge files from SP1 and the DVD.

Type the following command, replacing C:\InstallMedia with the location that you chose in step 2, C:\SP1Extract with the location that you chose in step 3, and C:\MergeFolder with the absolute path of the location that you chose in step 4:

msiexec /a C:\InstallMedia\vs_setup.msi /p C:\SP1Extract\TFS90sp1-KB949786.msp TARGETDIR=C:\MergeFolder

Note:
You must replace C:\MergeFolder with an absolute path, but you can replace C:\InstallMedia and C:\SP1Extract with absolute or relative paths.

From C:\MergeFolder (which you created in step 4), run setup.exe to install Team Foundation Server with SP1.

For some strange reason, and for my first installations, I kept missing this important section.