Overview
General. The Company is a holding company with interests in textiles and energy.
Textile Products. In 2007 and 2008, the Company derived all of its operating revenues from the textile activities of its Brookwood Companies Incorporated ("Brookwood") subsidiary; consequently, the Company's success is highly dependent upon Brookwood's success. Brookwood's success will be influenced in varying degrees by its ability to continue sales to existing customers, cost and availability of supplies, Brookwood's response to competition, its ability to generate new markets and products and the effect of global trade regulation. Although the Company's textile activities have generated positive cash flow in recent years, there is no assurance that this trend will continue.
While Brookwood has enjoyed substantial growth in its military business, there is no assurance this trend will continue. Brookwood's sales to the customers from whom it derives its military business have been more volatile and difficult to predict, a trend the Company believes will continue. In recent years, orders from the military for goods generally were significantly affected by the increased activity of the U.S. military. If this activity does not continue or declines, then orders from the military generally, including orders for Brookwood's products, may be similarly affected. Military sales of $21,194,000 and $81,148,000 for the 2008 third quarter and nine month periods, respectively, were 17.2% and 74.0% higher than the comparable periods in 2007 of $18,079,000 and $46,626,000.
The military had limited orders in 2006 and the 2007 first quarter for existing products and adopted revised specifications for new products to replace the products for which Brookwood's customers have been suppliers. However, the U.S. government released orders in the remaining 2007 quarters and into 2008 that include Brookwood's products, which resulted in a substantial increase in military sales. Changes in specifications or orders present a potential opportunity for additional sales; however, it is a continuing challenge to adjust to changing specifications and production requirements. Brookwood has regularly conducted research and development on various processes and products intended to comply with the revised specifications and participates in the bidding process for new military products. However, to the extent Brookwood's products are not included in future purchases by the U.S. government for any reason, Brookwood's sales could be adversely affected. In addition, the U.S. government is releasing contracts for shorter periods than in the past. The Company acknowledges the unpredictability in revenues and margins due to military sales and is unable at this time to predict future sales trends.
Unstable global nylon and chemical pricing and escalating energy costs, coupled with a varying product mix, have continued to cause fluctuations in Brookwood's margins, a trend that appears likely to continue.
Brookwood continues to identify new market niches intended to replace sales lost to imports. In addition to its existing products and proprietary technologies, Brookwood has been developing advanced breathable, waterproof laminates and other materials, which have been well received by its customers. Continued development of these fabrics for military, industrial and consumer applications is a key element of Brookwood's business plan. The ongoing success of Brookwood is contingent on its ability to maintain its level of military business and adapt to the global textile industry. There can be no assurance that the positive results of the past can be sustained or that competitors will not aggressively seek to replace products developed by Brookwood.
The U.S. textile industry has been and continues to be negatively impacted by existing worldwide trade practices, including the North American Free Trade Agreement ("NAFTA"), anti-dumping and duty enforcement activities by the U.S. Government and by the value of the U.S. dollar in relation to other currencies. The establishment of the World Trade Organization ("WTO") in 1995 has resulted in the phase out of quotas on textiles and apparel, effective January 1, 2005. Notwithstanding quota elimination, China's accession agreement for membership in the WTO provides that WTO member countries (including the United States, Canada and European countries) may re-impose quotas on specific categories of products in the event it is determined that imports from China have surged and are threatening to create a market disruption for such categories of products. During 2005, the United States and China agreed to a new quota arrangement, which will impose quotas on certain textile products through the end of 2008. In addition, the European Union also agreed with China on a new textile arrangement, which imposed quotas through the end of 2007. The European Union and China have announced that they will jointly monitor the volume of trade in a number of highly sensitive product categories during 2008. The United States may also unilaterally impose additional duties in response to a particular product being imported (from China or other countries) in such increased quantities as to cause (or threaten) serious damage to the relevant domestic industry (generally known as "anti-dumping" actions). In addition, China has imposed an export tax on all textile products manufactured in China; Brookwood does not believe this tax will have a material impact on its business.

Under NAFTA there are no textile and apparel quotas between the U. S. and either Mexico or Canada for products that meet certain origin criteria. Tariffs among the three countries are either already zero or are being phased out. Also, the WTO recently phased out textile and apparel quotas.
The U.S. has also approved the Central American Free Trade Agreement ("CAFTA") with several Central American countries (Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras and Nicaragua). Under CAFTA, textile and apparel originating from CAFTA countries will be duty and quota-free, provided that yarn formed in the United States or other CAFTA countries is used to produce the fabric. In addition, the United States recently implemented bilateral free trade agreements with Bahrain, Chile, Israel, Jordan, Morocco and Singapore. Although these actions have the effect of exposing Brookwood's market to the lower price structures of the other countries and, therefore, continuing to increase competitive pressures, management is not able to predict their specific impact.
The textile products business is not interdependent with the Company's other business operations. The Company does not guarantee the Brookwood bank facilities and is not obligated to contribute additional capital.
Engagement of Financial Advisor. In December 2007, a special committee of the board of directors of the Company engaged a financial advisor to assist it in developing strategic alternatives, including a potential sale, with respect to Brookwood. This initiative was terminated during the 2008 fourth quarter.
Energy. Hallwood Energy is a privately held independent oil and gas limited partnership and operates as an upstream energy company engaging in the acquisition, development, exploration, production, and sale of hydrocarbons, with a primary focus on natural gas assets. Hallwood Energy conducts its energy activities from its corporate office located in Dallas, Texas and production offices in Searcy, Arkansas and Lafayette, Louisiana. Hallwood Energy's results of operations are and will be largely dependent on a variety of factors, including, but not limited to fluctuations in natural gas prices; success of its drilling activities; the ability to transport and sell its natural gas; regional and national regulatory matters; and the ability to secure, and price of, goods and services necessary to develop its oil and gas leases. As of September 30, 2008, the Company owned approximately 22% of the blended Class A and Class C limited partner interests (18% after consideration of profit interests) of Hallwood Energy. In addition, the Company owned approximately 39% of the convertible notes issued by Hallwood Energy.
In June 2008, Hallwood Energy entered into an agreement for the sale and farmout to FEI Shale, L.P. ("FEI"), a subsidiary of Talisman Energy, Inc. of an undivided interest in up to 33.33% of Hallwood Energy's interest in substantially all its assets for a series of payments of up to $125,000,000 (an initial payment of $60,000,000 and the option to pay up to an additional $65,000,000), and entered into an agreement to provide consulting services to the purchaser for one year (the "Talisman Energy Transaction"). In October 2008, FEI elected to make a second payment of $30,000,000 to Hallwood Energy, which results in remaining potential funding from FEI of $35,000,000.
Refer also to the section "Investments in Hallwood Energy" for a further description of the Company's energy activities.
Presentation
The Company intends the discussion of its financial condition and results of operations that follows to provide information that will assist in understanding its financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect its financial statements.
Results of Operations
The Company reported net income for the 2008 third quarter of $1,255,000, compared to a net loss of $367,000 in 2007. Revenue for the 2008 third quarter was $35,568,000, compared to $32,576,000 in 2007.
Net income for the 2008 nine month period was $1,491,000, compared to a net loss of $8,264,000 in 2007. Revenue for the 2008 nine month period was $126,689,000, compared to $92,949,000 in 2007.

Revenues
Textile products sales of $35,568,000 increased by $2,992,000, or 9.2%, in the 2008 third quarter, compared to $32,576,000 in 2007. Sales for the nine month period increased by $33,740,000, or 36.3%, to $126,689,000, compared to $92,949,000 in 2007. The increases in the 2008 periods were principally due to an increase of sales of specialty fabric to U.S. military contractors, as a result of increased orders from the military to Brookwood's customers. Military sales accounted for $21,194,000 and $81,148,000 in the 2008 third quarter and nine month periods, respectively, compared to $18,079,000 and $46,626,000 in 2007. The military sales represented 59.6% and 55.5% of Brookwood's net sales in the 2008 and 2007 third quarters, respectively, and 64.1% and 50.2% in the 2008 and 2007 nine month periods, respectively.
Sales to one customer, Tennier Industries, Inc. ("Tennier") accounted for more than 10% of Brookwood's net sales during both the 2008 and 2007 three month and nine month periods. Its relationship with Tennier is ongoing. Sales to Tennier, which are included in military sales, were $8,593,000 and $38,573,000 in the 2008 third quarter and nine month periods, respectively, compared to $11,270,000 and $26,840,000 in 2007. Sales to Tennier represented 24.2% and 34.6% of Brookwood's net sales in the 2008 and 2007 quarters, respectively, and 30.4% and 28.9% in the 2008 and 2007 nine month periods, respectively. Sales to another customer, ORC Industries, Inc. ("ORC") accounted for more than 10% of Brookwood's sales in 2008. Its relationship with ORC is ongoing. Sales to ORC, which are included in military sales, were $4,093,000 and $13,375,000 in the 2008 third quarter and nine month periods, respectively, compared to $1,932,000 and $6,162,000 in 2007. Sales to ORC represented 11.5% and 5.9% of Brookwood's net sales in the 2008 and 2007 third quarters, respectively, and 10.6% and 6.6% in the 2008 and 2007 nine month periods, respectively.
Expenses
Textile products cost of sales of $27,715,000 for the 2008 third quarter increased by $1,666,000, or 6.4%, compared to $26,049,000 in 2007. For the nine month period, textile products cost of sales of $94,234,000 for 2008 increased by $17,938,000, or 23.5%, compared to $76,296,000 in 2007. The 2008 increases principally resulted from material and labor costs associated with the higher sales volume, changes in product mix and utility costs, which increased 68% and 59% in the 2008 third quarter and nine month periods compared to the 2007 periods. Cost of sales includes all costs associated with the manufacturing process, including but not limited to, materials, labor, utilities, depreciation on manufacturing equipment and all costs associated with the purchase, receipt and transportation of goods and materials to Brookwood's facilities, including inbound freight, purchasing and receiving costs, inspection costs, internal transfer costs and other costs of the distribution network and associated manufacturer's rebates. Brookwood believes that the reporting and composition of cost of sales and gross margin is comparable with similar companies in the textile converting and finishing industry.
The increased gross profit margin for the 2008 third quarter, 22.1% versus 20.0%, and for the 2008 nine month period, 25.6% versus 17.9%, principally resulted from higher sales volume, changes in product mix and manufacturing efficiencies such as reductions to material working loss.
Administrative and selling expenses were comprised of the following (in thousands):

                                 Three Months Ended          Nine Months Ended
                                    September 30,              September 30,
                                  2008          2007         2008          2007

            Textile products   $    4,452      $ 3,905     $  12,913     $ 10,880
            Corporate               1,508        1,374         3,813        3,730

            Total              $    5,960      $ 5,279     $  16,726     $ 14,610

Textile products administrative and selling expenses of $4,452,000 for the 2008 third quarter increased by $547,000, or 14.0%, from 2007. For the nine months, selling and administrative expenses increased by $2,033,000, or 18.7%, compared to 2007. The increase for the 2008 third quarter from the 2007 quarter was primarily attributable to an increase of $200,000 of employee related expenses (e.g. salaries and benefits) related to the higher sales volume, as well as in support of increased compliance requirements for Sarbanes-Oxley and environmental matters, $173,000 for provision of doubtful accounts and an increase of $276,000 for legal and professional fees, partially offset by a $60,000 reduction in commissions. The increase for the 2008 nine month period was primarily attributable to an increase of $1,308,000 of employee related expenses related to higher sales volume, as well as in support of increased compliance requirements for Sarbanes-Oxley and environmental matters, $174,000 of increased factor commissions,

$104,000 for provision of doubtful accounts and an increase of $566,000 for legal and professional fees, partially offset by $128,000 of one-time 2007 first quarter relocation expenses related to Brookwood Laminating's move to Connecticut. The textile products administrative and selling expenses included items such as payroll, professional fees, sales commissions, marketing, rent, insurance, travel and royalties. Brookwood conducts research and development activities related to the exploration, development and production of innovative products and technologies. Research and development costs were approximately $210,000 and $121,000 for the 2008 and 2007 third quarters, respectively and $668,000 and $448,000 in the 2008 and 2007 nine month periods, respectively.
Corporate administrative expenses increased $134,000, or 9.7%, for the 2008 third quarter, compared to 2007. For the nine months, corporate expenses increased $83,000, or 2.2%, compared to 2007. The increase for the 2008 third quarter was principally attributable to higher professional fees of $141,000, including costs related to the special committee's activities in considering the Company's investment in Hallwood Energy and strategic alternatives with respect to Brookwood, partially offset by a decrease in Sarbanes-Oxley costs of $40,000. The increase for the 2008 nine month period was principally attributable to higher professional fees of $176,000 and higher office space and administrative service costs for HIL of $105,000, partially offset by reduced Sarbanes-Oxley costs of $201,000.
Other Income (Loss)
Equity income (loss) from the Company's investments in Hallwood Energy, attributable to the Company's share of loss in Hallwood Energy, was zero in the 2008 third quarter, compared to a loss of $1,272,000 in 2007. The equity loss for the 2008 nine month period was $12,120,000, compared to a loss of $13,648,000 in 2007. In the 2008 third quarter, Hallwood Energy reported a loss of $1,938,000, which included an impairment of its oil and gas properties of $3,742,000, interest expense of $858,000 (including an offset of $6,374,000 attributable to the make-whole fee) and other income of $3,227,000, which principally relates to the contract services agreement with Talisman. In the 2007 third quarter, Hallwood Energy reported a loss of $5,344,000, which included interest expense of $3,711,000 (including $190,000 attributed to the make-whole fee. The make-whole fees were included in interest expense. The Company recorded the equity losses in the 2008 periods to the extent of loans it made to Hallwood Energy in 2008 of $8,920,000 and a guarantee to invest additional funds up to $3,200,000 and reduced the carrying value of its investment in Hallwood Energy to zero. For the 2008 nine month period, Hallwood Energy reported a loss of $23,826,000, compared to loss of $54,602,000 for the 2007 nine month period. As of September 30, 2008, the Company's proportionate share of Hallwood Energy's accumulated losses that have not been recognized is approximately $3,572,000, based upon a 25% Class A ownership percentage.
The Company earned interest income of $-0- and $92,000 for the 2007 third quarter and nine month periods, respectively, which was accrued but not paid in cash on loans it made to Hallwood Energy in the period from March to May 2007.
Interest expense was $139,000 and $567,000 in the 2008 third quarter and nine month periods, respectively, compared to $301,000 and $810,000 in the 2007 periods. Interest expense principally relates to Brookwood's Key Bank revolving credit facility. The decreases in interest expense were due to lower interest rates and lower principal balances.
Interest and other income was $30,000 and $72,000 in the 2008 third quarter and nine month periods, respectively, compared to $33,000 and $269,000 in the 2007 periods. The 2008 decreases were principally due to a gain in the amount of $74,000 from the sale of a marketable security sold in March 2007, and reduced interest income earned on lower balances of cash and cash equivalents.

                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
Item 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
          OF OPERATIONS


   Income Taxes
   Following is a schedule of income tax expense (benefit) (in thousands):

                              Three Months Ended          Nine Months Ended
                                 September 30,              September 30,
                              2008           2007         2008          2007
                Federal
                Deferred    $     317       $  (168 )   $     438     $ (4,259 )
                Current          (109 )           -          (109 )          -

                Sub-total         208          (168 )         329       (4,259 )

                State
                Deferred            -             -             -          (43 )
                Current           321           243         1,294          512

                Sub-total         321           243         1,294          469


                Total       $     529       $    75     $   1,623     $ (3,790 )

At September 30, 2008, the deferred tax asset was attributable to temporary differences, that upon reversal, could be utilized to offset income from operations, a net operating loss carryforward and alternative minimum tax credits. The effective federal tax rate in both periods was 34%, while state taxes are determined based upon taxable income apportioned to those states in which the Company does business at their respective tax rates.
Investments in Hallwood Energy
At September 30, 2008, the Company had invested $61,481,000 in Hallwood Energy, which represented approximately 22% of the blended Class A and Class C limited partner interests (18% after consideration of profit interests) of Hallwood Energy and, in addition, the Company loaned Hallwood Energy $13,920,000 in the form of convertible notes. The Company accounts for this investment using the equity method of accounting and records its pro rata share of Hallwood Energy's net income (loss) and partner capital transactions as appropriate.
Hallwood Energy is a privately held independent oil and gas limited partnership and operates as an upstream energy company engaging in the acquisition, development, exploration, production, and sale of hydrocarbons, with a primary focus on natural gas assets. Hallwood Energy conducts its energy activities from its corporate office located in Dallas, Texas and production offices in Searcy, Arkansas and Lafayette, Louisiana. Hallwood Energy's results of operations are and will be largely dependent on a variety of factors, including, but not limited to fluctuations in natural gas prices; success of its drilling activities; the ability to transport and sell its natural gas; regional and national regulatory matters; and the ability to secure, and price of, goods and services necessary to develop its oil and gas leases; and the ability to raise additional capital.
Hallwood Energy's management has classified its energy investments into three identifiable geographical areas:
• West Texas - the Barnett Shale and Woodford Shale formations,
• Central and Eastern Arkansas - primary targets are the Fayetteville Shale and Penn Sand formations, and
• South Louisiana - various projects on and around the LaPice Salt Dome.

Certain of the Company's officers and directors are investors in Hallwood Energy. In addition, as members of management of Hallwood Energy, one director and officer and one officer of the Company hold a profit interest in Hallwood Energy.
In January 2008, the Company loaned $5,000,000 to Hallwood Energy as part of a $30,000,000 convertible subordinated note agreement (discussed below).
In May 2008, June 2008 and September 2008, the Company loaned $2,961,000, $2,039,000 and $4,300,000, respectively, (for a total of $9,300,000) pursuant to the Equity Support Agreement in connection with the Talisman Energy Transaction (discussed below).
The Company's proportionate share of Hallwood Energy's calendar year 2007 loss would have reduced the carrying value of its investment in Hallwood Energy below zero. The general rule for recording equity losses ordinarily indicates that the investor shall discontinue applying the equity method when the investment has been reduced to zero and shall not provide for additional

losses unless the investor provides or commits to provide additional funds in the investee, has guaranteed obligations of the investee, or is otherwise committed to provide further financial support to the investee. Although no guarantee or commitment existed at December 31, 2007, the Company loaned $5,000,000 to Hallwood Energy in January 2008 in connection with Hallwood Energy's issuance of up to $30,000,000 of convertible subordinated note due January 21, 2011 (the "First Convertible Note") to provide capital to continue regular ongoing operations. Accordingly, the Company recorded an additional equity loss in 2007 to the extent of the $5,000,000 loan, as the Company had not determined to what extent, if any, that it would advance additional funds to Hallwood Energy.
In connection with the then ongoing efforts to complete the Talisman Energy Transaction, the Company loaned Hallwood Energy $2,961,000 on May 15, 2008. As of that date, the Company's management had indicated that it did not intend to make additional investments in Hallwood Energy, except in connection with Hallwood Energy's obtaining additional funds from external sources. Due to the uncertainties at that time related to the completion of the Talisman Energy Transaction and the Company's additional investment, if any, the Company recorded an equity loss for the 2008 first quarter to the extent of the $2,961,000 loan. The Company's carrying value of its Hallwood Energy investment was zero at March 31, 2008.
As a result of the completion of the Talisman Energy Transaction in June 2008, the Company entered into the Equity Support Agreement with Hallwood Energy which obligated the Company to contribute additional equity or debt capital of $2,039,000 (for a total of $5,000,000) at the completion date to Hallwood Energy and guarantee an additional amount of up to $7,500,000 in certain circumstances, both of which were to be issued under the terms of the Second Convertible Note (discussed below). The Company's commitment to provide additional financial support, resulted in the recording of an equity loss in the 2008 second quarter of $9,159,000, which included accumulated equity losses that had not been previously recorded as the Company reduced the carrying value of its investment to zero. The Company's carrying value of its Hallwood Energy investment was zero at September 30, 2008.
Capital Transaction in 2008. On June 10, 2008, Hallwood Energy entered into an agreement for the sale and farmout to FEI Shale, L.P. ("FEI"), a subsidiary of Talisman Energy, Inc. of an undivided interest in up to 33.33% of Hallwood Energy's interest in substantially all its assets for a series of payments of up to $125,000,000 (an initial payment of $60,000,000 and the option to pay up to an additional $65,000,000), and entered into an agreement to provide consulting services to the purchaser for one year (the "Talisman Energy Transaction"). FEI prepaid the consulting services agreement which requires two man-weeks per month of service from two senior executives. The revenues from this agreement will be recognized as earned over the course of the twelve month period. In October 2008, FEI elected to make a second payment of $30,000,000 to Hallwood Energy, which results in remaining potential funding from FEI of $35,000,000. . . .