Michael Shulman

Live Well, Thanks to Dying Companies

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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?