A principal qualification for consideration as a Rule Maker is a bright future. We have labeled it "expanding possibilities" but, simply put, we mean opportunity. We want to own companies that not only realize the grass is greener on the other side of the fence, but are plotting a strategy to get there. Recognizing the wireless industry as one of those greener pastures is easy. What isn't so easy is understanding how third-party activities can threaten it.

Wireless systems will eventually replace wire-based systems wherever possible. This is not to say that all the fiber being laid these days will go dark, but rather that most copper lines will, especially the short-haul lines. The simple fact is that terrestrial-based systems are more expensive than wireless systems.

Fiber is expensive, just ask the Corning (NYSE: GLW) executives. Laying fiber is not cheap either. The guys over at Global Crossing (NYSE: GX) would be happy to quote you a price. And besides being one of the dullest jobs on the planet (IMHO), securing right-of-way easements has got to add up when you figure in the legal fees. These infrastructure costs, while still necessary, are significantly reduced with a wireless infrastructure. This is a competitive advantage. Sure, we will still use fiber to carry traffic from Denver to Chicago, but fiber into every American household... sorry, it ain't gonna happen.

Wireless systems, however, have a major expense terrestrial-based systems don't -- air rights -- and they don't come cheap. In fact, Washington has collected billions for the rights to airwaves. It's all about the latest hot commodity -- spectrum. Understanding spectrum is paramount to understanding the wireless industry, specifically the wireless service providers.

First, investors should understand how spectrum is parceled. The Federal Communications Commission  (FCC) controls the airwaves over the U.S., and since 1994 it has been auctioning off designated spectrum frequencies to the highest bidder. Prior to 1994, believe it or not, the FCC gave away spectrum licenses.

The FCC divided up the usable spectrum into hundreds of different sub-sectors. For example, cordless telephones got 43.69-50 MHz, FM radio broadcasting got 88-108 MHz, and so on. A fascinating list of what frequencies are used for can be found here. After dividing the spectrum by sectors the FCC divided it again by geography. There are two main sub-sectors allocated to digital phone service in the U.S: Digital Advanced Mobile Phone Service (D-AMPS) and Personal Communications Service (PCS). The majority of the wireless service providers in the U.S. operate on one of these two frequency bands. Other notable spectrum allocations are the analog systems, also known as Advanced Mobile Phone Service (AMPS) and Specialized Mobile Radio which is primarily used by Nextel Communications (Nasdaq: NXTL).

In order to promote competition, the FCC originally auctioned off two D-AMPS licenses in each sub-sector. Later, it split the PCS spectrum up to allow six competitors in each region. This was done to increase license revenues for the government and to lower prices by increasing competition. Suddenly, each geographic region could have as many as eight "wireless phone systems" in each market -- two D-AMPS and six PCS.

Acquiring the necessary licenses via the unfavorable (expensive) auction format led to huge debt levels at the wireless service providers. The FCC is currently auctioning off 422 licenses in 195 markets and many are looking at this auction to be a precursor to future auctions. Cost is the issue.

Wireless services providers (and investors) around the world were spooked when the British government raked in over $35 billion in its latest spectrum auction. The Germans followed that up with an even bigger windfall. American investors began worrying about the remaining U.S. auctions. How can wireless service providers afford billions in spectrum rights on top of the billions it will cost to upgrade their systems?

It seems that U.S. firms have found a way around this costly process by sharing, which means they don't always have to go head-to-head in an auction. According to a recent Wall Street Journal article, "most of the big U.S. wireless carriers have been swapping licenses to fill in the gaps in their networks" rather than trying to outspend each other. Paul Larson provides several examples of this in his overview of wireless service providers in Industry Focus 2001. He calls it "trading horses" and points out that Cingular and VoiceStream Wireless (Nasdaq: VSTR) exchanged licenses. So have AT&T Wireless (NYSE: AWE) and Sprint PCS (NYSE: PCS).

AT&T executives had to address this very issue on the conference call regarding the NTT's (OTC: NTDMY) $9 billion investment in the company. Analysts were concerned that AT&T would have to spend more to acquire the necessary spectrum to operate a W-CDMA-based network. Apparently there was some confusion about whether AT&T could operate a W-CDMA network over the current licenses it owned. Management stated that it could still provide coverage in 70% of its markets without purchasing new spectrum. They assured investors that even though the company was switching from a TDMA-based network to a W-CDMA-based network, its spectrum licenses were adequate.

Investors in wireless service providers should keep a close eye on the current FCC auction, which could rake in as much as $10 billion for the government. Can service providers afford this?

A final word to my fellow investors out there. I feel your pain. Hang in there. The fundamentals are not as bad as the market sentiment.

Have a happy and safe holiday season.

Fool on.