Less than a year after its initial public offering, Vonage’s (VG) voice-over-Internet broadband telephone services conjured up little more than dead air for investors on the long side. But those of us who played it on the way down were able to turn the company’s woes into some serious short-side profits.

Now, I know some of you will hear the word “short-side” and be intrigued but also feel a little bit guilty at the thought of profiting from a company’s misfortune. However, had we not identified Vonage as a company that was breaking down — and if we hadn’t purchased put option contracts to serve as our bearish bet on this company’s prospects — we wouldn’t have made an average 108% gain when we closed out two winning positions in this “bad company”!

Vonage was a pioneer in third-party services for individuals, and investment bankers begged it for several years to go public, which it did in May 2006 in what is generally viewed as the most-bungled IPO in living memory. The stock not only fell by 50% soon afterward, but the company had also offered customers stock from the IPO, assuming the price would go up. Oops!

The company then compounded its mistake by declaring that those customers not wanting to accept and pay for their shares would still have to. Double oops — the company managed, in one week, to alienate its customers and its investors.

It takes real talent to pull off that kind of a double-play — and yet they turned it into a triple-play late last year when brokerages serving those customers unwilling to pay for IPO shares told these folks to either pay up or have their assets frozen.

Real good customer relations and retention, eh?

The ChangeWave Shorts service launched in October 2006, and a short-side play on Vonage was our very first recommendation. We had been receiving steady feedback from ChangeWave Alliance survey data, showing that consumers were increasingly turning off to Vonage. The quirky commercials were attracting attention, sure, but those weren’t enough to keep customers plugged in to the company’s VOIP services.

At the time, its competitors were offering VOIP for significantly cheaper prices, and Verizon’s fiber-to-the-premises initiative had arrived, as did increased competition from cable companies offering bundled phone, Internet and cable services to customers. How was Vonage to compete?

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On Oct. 20, 2006, we recommended buying the VG April 7.50 Puts for $1.40, just a few days before the company announced earnings — or, rather, a lack thereof. After that non-event, we declared that it was “a dead company; it’s just that nobody came to collect the body yet.”

How dead? Its losses totaled $62 million, or 40 cents per share, on revenues of $161 million. On top of that, not only did subscriber acquisition drop by 52,000 from the prior quarter, but those acquisition costs increased 6% to $254 apiece — and customers on the basic residential plan only paid $15 a month. Ouch! Subscriber churn increased almost 12%, from 2.3% of customers to 2.6% leaving the service. At that rate, we figured the company would be out of cash in 10 quarters, tops.

Data like this gives you the patience to stick it out on those (temporary) occasions when a position starts to turn against you. Don’t get me wrong — the gains in Vonage were ultimately worth the wait. But despite these abysmal numbers, VG mysteriously managed to have a few good days in the markets, which proved for a few frustrating days but ultimately, our fundamental analysis was spot-on, and we were rewarded for it.

This story is one of my favorites because it goes to show that an ebullient market can only keep sinking ships afloat for only so long — if a company is failing or has too many problems to remain profitable for an extended amount of time, eventually Wall Street is going to catch on and the stock will go in the “right” direction — and for us here on the short side, that direction is down!

We were able to take some nice post-Valentine’s profits on Feb. 15, 2007, when shares of Vonage opened 40 cents lower. No surprises there — the stock had been in a freefall for a long time, but what that meant for us was that our VG April 7.50 Puts had spiked to $2, representing a 42.86% gain for our short-side position.

But we didn’t think Vonage’s slide was over — not by a long shot. So, we recommended that subscribers bank the profits and “roll” the original investment capital into a new position — this time, into the VG July 5 Puts — so we could buy a little more time to capture the downside we knew was coming.

We were able to get in for a mere 60 cents — and that was a bargain, considering that put-trading activity in VG was increasing as others started to get the hint that this company wasn’t going to make a quick recovery, if it ever could.

What might have held up VG so long has been the fact that it’s what we call a “cult” stock — names like Vonage, Netflix (NFLX) and Palm (PALM) are among the elite group of names that people “love” because they use their products. Or, if they aren’t using them, they at least know of them — those ubiquitous names that have memorable advertisements and a disproportionate number of shares in the hands of individuals or fund managers who actually purchase and use the products or services.

The best way to capture short-side profits is to get situated on the short side before the big-money investors start bailing from the long side. The pattern is simple: First, they leave the products. Then, they leave the stock. Finally, they start looking at the short side, and the real sweet spot for us is being able to sell them our option contracts for a much-higher premium than we’d paid for them!

And we did just that with Vonage. In early April, a piece of bad news for Vonage served as a catalyst that took our position from profitable to downright explosive. One of the banks that had brought it public — Citigroup (C) — put a “Sell” recommendation on the stock and said there was a one-third chance it would go bankrupt sometime in 2008 — a prediction we’d been making all along!

Remember, this was a company that’s only been public for less than a year — those comments sounded the death knell for Vonage, which prompted us to ring the cash register on our VG July 5 Puts for $1.65 — a cool 175% gain from our initial 60-cent entry price!

So, all told, we cashed out two positions in the same name for an average 108% gain. Now, hold on a moment — before you start feeling sorry for one of these “cult favorites,” think about it this way. Would you rather pay (probably too much) money for their products, or would you rather make money from the fact that nobody wants to buy them?

If you enjoyed this article, check out Michael Shulman’s “Issues With Shorting Stocks” and “Financial Transparency Too Little Too Late.”