Overview
General. The Company currently operates as a holding company with interests in textile products and energy.
Textile Products. In 2008 and 2009, 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 that this trend will continue. Brookwood's sales to the customers from whom it derives its military business have been 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 $28,394,000 for the 2009 first quarter were $236,000, or 0.8%, higher than the comparable period amount of $28,158,000 in 2008.
From time to time, the military limits orders for existing products and adopts revised specifications for new products to replace the products for which Brookwood's customers have been suppliers. The U.S. government released orders in 2007 and 2008 that include Brookwood's products, which resulted in a substantial increase in military sales over prior periods. 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 volatile domestic energy costs, coupled with a varying product mix, have continued to cause fluctuations in Brookwood's margins, a trend that will potentially 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"), the Central American Free Trade Agreement ("CAFTA"), 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 generally resulted in the phase out of quotas on textiles and apparel, effective January 1, 2005. Brookwood does not believe these developments will have a material impact on its business.
Under NAFTA and CAFTA there are no textile and apparel quotas between the U. S. and the other parties for products that meet certain origin criteria. Tariffs among the countries are either already zero or are being phased out. 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 facility and is not obligated to contribute additional capital. Conversely, Brookwood does not guarantee debts of the Company or any of the Company's subsidiaries and is not obligated to contribute additional capital to the Company beyond dividend payments and the tax sharing agreement.

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 office in Searcy, Arkansas. As of March 31, 2009, the Company had invested $61,480,000 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. In addition, the Company loaned Hallwood Energy $13,920,000 in the form of convertible notes issued by Hallwood Energy.
On March 1, 2009, Hallwood Energy, HEM (the general partner of Hallwood Energy) and Hallwood Energy's subsidiaries, filed petitions for relief under Chapter 11 of the United States Bankruptcy Code. The cases are pending in the United States Bankruptcy Court for the Northern District of Texas, Dallas Division, in In re Hallwood Energy, L.P., et al Case No. 09-31253. The Company is only an investor in and creditor of Hallwood Energy. The bankruptcy filing does not include the Company or any other of its assets. For a further discussion of the bankruptcy case, refer to the section entitled "Investments in Hallwood Energy - Bankruptcy Filing by Hallwood Energy".
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 of $2,954,000 for the quarter ended March 31, 2009, compared to net income of $1,566,000 in 2008. Revenue for the 2009 first quarter was $39,667,000, compared to $43,987,000 in 2008.
Revenues
Textile products sales of $39,667,000 decreased by $4,320,000, or 9.8%, in the 2009 first quarter, compared to $43,987,000, in 2008. The decrease was principally due to a decrease in the commercial market segment, as well as sail cloth, flag and other customers and products affected by the current economic downturn. Sales of specialty fabric to U.S. military contractors were stable in the 2009 first quarter, as compared to the 2008 first quarter. Military sales accounted for $28,394,000 and $28,158,000 in the 2009 and 2008 first quarters, which represented 71.6% and 64.0% of Brookwood's sales, respectively.
Brookwood has several customers who accounted for more than 10% of Brookwood's sales in the 2009 and 2008 periods. Sales to one Brookwood customer, Tennier Industries, Inc. ("Tennier"), accounted for more than 10% of Brookwood's sales during both the 2009 and 2008 periods. Its relationship with Tennier is ongoing. Sales to Tennier, which are included in military sales, were $11,874,000 in the 2009 first quarter, compared to $14,868,000 in the 2008 first quarter, which represented 29.9% and 33.8% of Brookwood's sales, respectively. Sales to another customer, ORC Industries, Inc. ("ORC"), accounted for more than 10% of Brookwood's sales in 2009. Its relationship with ORC is ongoing. Sales to ORC, which are included in military sales, were $6,671,000, in the 2009 first quarter, compared to $4,029,000 in the 2008 first quarter, which represented 16.8% and 9.2% of Brookwood's sales, respectively. Sales to another customer accounted for slightly more than 10% of sales for 2008 only. Brookwood's relationship with the customer is ongoing. Sales to that customer, which are also included in military sales, were $2,844,000 in the 2009 first quarter, compared to $4,655,000 in the 2008 first quarter which represented 7.2% and 10.6% of Brookwood sales, respectively.

Expenses
Textile products cost of sales of $29,403,000 for the 2009 first quarter decreased by $3,149,000, or 9.7%, compared to $32,552,000 in 2008. The 2009 decrease principally resulted from reduced sales volume, changes in product mix, and reduced utility costs which decreased 21% in the 2009 first quarter compared to the 2008 first quarter. 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 gross profit margin for the 2009 first quarter, as compared to the 2008 first quarter, (25.9% versus 26.0%) remained stable. Lower sales volume-related increases were offset by changes in product mix, manufacturing efficiencies such as reductions in material working loss and energy savings.
Administrative and selling expenses were comprised of the following (in thousands):

                                           Three Months Ended
                                                March 31,
                                            2009          2008
                      Textile products   $    4,405      $ 4,032
                      Corporate               1,079        1,181


                      Total              $    5,484      $ 5,213

Textile products administrative and selling expenses of $4,405,000 for the 2009 first quarter increased by $373,000, or 9.3%, from the 2008 amount of $4,032,000. The increase in the 2009 first quarter from the 2008 first quarter was primarily attributable to an increase of $448,000 in professional services, principally legal fees, and $217,000 of employee related expenses (e.g. salaries and benefits) and was partially offset by reduced costs of $251,000 related to performance and other related payroll costs and $34,000 in factor commissions due to lower sales. The textile products administrative and selling expenses included items such as payroll, professional fees, sales commissions, factor 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 $225,000 and $252,000 in the 2009 and 2008 quarters, respectively.
Corporate administrative expenses were $1,079,000 for the 2009 first quarter, compared to $1,181,000 for 2008. The decrease of $102,000, or 8.6%, was principally attributable to decreased employee related expenses of $120,000 due to a reduction in staff, partially offset by increased professional fees of $59,000.
Other Income (Loss)
Equity loss from the Company's investments in Hallwood Energy, attributable to the Company's proportionate share of loss in Hallwood Energy, to the extent of its investment and commitment to provide additional financial support to Hallwood Energy, was zero in the 2009 first quarter, compared to $2,961,000 in 2008. In the 2009 first quarter, Hallwood Energy reported a loss of $6,000, which included an impairment of its oil and gas properties of $11,499,000 and a benefit related to a reduction in the fair value of make-whole fees associated with Hallwood Energy's debt of $11,371,000. The Company did not record an equity loss in the 2009 first quarter as it had previously reduced the carrying value of its investment in Hallwood Energy to zero, and it discontinued applying the equity method because it has not provided or committed to provide additional funds or financial support to Hallwood Energy. In the 2008 first quarter, Hallwood Energy reported a loss of $10,288,000, which included an expense of $4,750,000 in regards to a settlement of a lawsuit. The make-whole fee was included in interest expense. The Company recorded the equity loss in the 2008 first quarter to the extent of the $2,961,000 loan it made to Hallwood Energy in May 2008 and reduced its carrying value of its investment in Hallwood Energy to zero. As of March 31, 2009, the Company's proportionate share of Hallwood Energy's accumulated losses that have not been recognized is approximately $12,892,000, based upon the Company's 25% Class A limited partner ownership percentage.

Interest expense of $72,000 in the 2009 first quarter and $247,000 for the 2008 first quarter is principally related to Brookwood's Working Capital Revolving Credit Facility. The decrease in interest expense was due to a decrease in the average outstanding loan amount and lower interest rates (2.02% and 4.63% at March 31, 2009 and 2008, respectively).
Interest and other income was $11,000 in the 2009 first quarter, compared to $18,000 in 2008. The 2009 decrease was principally due reduced interest income earned on lower balances of cash and cash equivalents.
Income Taxes
Following is a schedule of income tax expense (in thousands):

                                       Three Months Ended
                                            March 31,
                                        2009          2008
                         Federal
                         Deferred    $    1,522      $   807
                         Current              -            -

                         Sub-total        1,522          807

                         State
                         Deferred             -            -
                         Current            243          659

                         Sub-total          243          659


                         Total       $    1,765      $ 1,466

At March 31, 2009, the deferred tax asset was attributable to temporary differences, that upon reversal, could be utilized to offset income from operations, a federal net operating loss carryforward and alternative minimum tax credits. The effective federal tax rate in both periods was 34%, while state taxes were 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 March 31, 2009 and December 31, 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). In addition, the Company loaned Hallwood Energy $13,920,000 in the form of convertible notes issued by Hallwood Energy. The Company accounts for the investment in Hallwood Energy using the equity method of accounting and records its pro rata share of Hallwood Energy's net income (loss) and partners' capital transactions, as appropriate.
On March 1, 2009, Hallwood Energy, HEM (the general partner of Hallwood Energy) and Hallwood Energy's subsidiaries, filed petitions for relief under Chapter 11 of the United States Bankruptcy Code. The cases are being jointly administered and pending in the United States Bankruptcy Court for the Northern District of Texas, Dallas Division, in In re Hallwood Energy, L.P., et al Case No. 09-31253. The Company is only an investor in and creditor of Hallwood Energy. The bankruptcy filing does not include the Company or any other of its assets.
As a result of the bankruptcy filing by Hallwood Energy, the extent or value of the Company's continuing interest in Hallwood Energy, if any, is uncertain. For a further discussion of the bankruptcy case, refer to the section below entitled "Bankruptcy Filing by Hallwood Energy".
Hallwood Energy's management has classified its energy investments into two identifiable geographical areas:
• Central and Eastern Arkansas - primary targets are the Fayetteville Shale and Penn Sands formations.

• West Texas - the Barnett Shale and Woodford Shale formations,

Certain of the Company's officers and directors are investors in Hallwood Energy. In addition, as a member of management of Hallwood Energy, one officer of the Company holds a profit interest in Hallwood Energy.
Equity Losses. 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.
In connection with the then ongoing efforts to complete the Talisman Energy Transaction (discussed below), the Company loaned Hallwood Energy $2,961,000 in May 2008. Concurrent with the completion of the Talisman Energy Transaction in June 2008, the Company entered into an Equity Support Agreement (the "Equity Support Agreement") with Hallwood Energy under which the Company committed under certain conditions to contribute equity or debt capital to Hallwood Energy to maintain a reasonable liquidity position for Hallwood Energy or prevent or cure any default under Hallwood Energy's credit facilities with respect to interest payments, up to a maximum amount of $12,500,000. The Company contributed $2,039,000 at the completion date (for a total amount of $5,000,000) to Hallwood Energy and committed to provide an additional amount of up to $7,500,000 in certain circumstances, all of which were issued under the terms of the Second Convertible Note (discussed below). Due to the uncertainties in May 2008 related to the completion of the Talisman Energy Transaction and the Company's additional investments, if any, the Company recorded an equity loss for the 2008 first quarter to the extent of the $2,961,000 loan.
An obligation and related additional equity loss was recorded in the 2008 second quarter to the extent of the Company's commitment to provide additional financial support to Hallwood Energy pursuant to the Equity Support Agreement, in accordance with generally accepted accounting principles. The Company's carrying value of its Hallwood Energy investment, which was zero at December 31, 2008 and 2007, remained at zero as of March 31, 2009.
The Company's proportionate share of Hallwood Energy's accumulated losses that have not been recognized as of March 31, 2009 is approximately $12,892,000, based upon its 25% Class A limited partner ownership percentage.
In addition to the description of Hallwood Energy's activities provided in the Company's 2008 Form 10-K, further information regarding Hallwood Energy is provided below.
Loan Facilities and Convertible Notes. At March 31, 2009, Hallwood Energy has two loan facilities and two convertible note issues:
• Senior Secured Credit Facility and Junior Credit Facility. In April 2007, Hallwood Energy entered into a $100,000,000 loan facility (the "Senior Secured Credit Facility") with a lender ("Hallwood Energy's Lender"), who is an affiliate of one of Hallwood Energy's investors. With an initial draw of $65,000,000 in April 2007, most of which was used to repay a former credit facility, and subsequent draws, the Senior Secured Credit Facility was fully funded in October 2007. The outstanding principal balance was $100,000,000 at March 31, 2009 and December 31, 2008.

The Senior Secured Credit Facility, including its amendments, contains various financial covenants, including maximum general and administrative expenses and current and proved collateral coverage ratios and non-financial covenants that restrict Hallwood Energy's activities The Senior Secured Credit Facility contains a make-whole provision whereby Hallwood Energy is required to pay Hallwood Energy's Lender the amount by which the present value of interest and principal from the date of prepayment through January 31, 2010, exceeds the principal amount on the prepayment date.

In January 2008, Hallwood Energy entered into a $15,000,000 loan facility (the "Junior Credit Facility") with Hallwood Energy's Lender and drew the full $15,000,000 available. Borrowings under the Senior Secured Credit Facility and Junior Credit Facility (collectively referred to as the "Secured Credit Facilities") are both secured by Hallwood Energy's oil and gas leases and mature on February 1, 2010. The Junior Credit Facility contains various financial covenants and a make-whole provision, materially consistent with the Senior Secured Credit Facility.

Hallwood Energy was not in compliance with the general and administrative expense covenant at March 31, 2008 and the current ratio covenant as of April 30, 2008 required by the Secured Credit Facilities. Hallwood Energy entered into an amendment of the facilities with Hallwood Energy's Lender in June 2008 to waive the defaults and amend various covenants.

At September 30, 2008 and December 31, 2008, Hallwood Energy was not in compliance with the proved collateral coverage ratio under the Secured Credit Facilities. Accordingly, the interest rate under those facilities is now the defined LIBOR rate plus 12.75% per annum. However, pursuant to a forbearance agreement related to the Talisman Energy Transaction, Hallwood Energy's Lender agreed not to exercise its other remedies under the facilities until at least 91 days after the termination of the farmout agreement.

To the extent Hallwood Energy was not in default by virtue of pre-March 1, 2009 events, the bankruptcy filing on March 1, 2009 constituted a default under the terms of the Secured Credit Facilities and the forbearance agreement was terminated by its terms upon the bankruptcy filing. However, under the automatic stay provisions of the Bankruptcy Code, Hallwood Energy's Lender has not been able to foreclose on its collateral. Hallwood Energy's obligations under the Secured Credit Facilities are the subject of litigation commenced by Hallwood Energy against Hallwood Energy's Lender, as more fully described in the section below entitled "Litigation".

• First Convertible Note. In January 2008, Hallwood Energy entered into a $30,000,000 convertible subordinated note agreement (the "First Convertible Note"). Borrowings bear interest at an annual rate of 16%, payable on a quarterly basis after the completion of a defined equity offering and subject to the prior full payment of borrowings and accrued interest under the Secured Credit Facilities. The First Convertible Note and accrued interest may be converted into Class C interests, or comparable securities, on a dollar for dollar basis. As of March 31, 2009, $28,839,000 principal amount of the First Convertible Notes were outstanding, of which the Company held $5,000,000.

• Second Convertible Note. In May 2008, Hallwood Energy entered into a $12,500,000 convertible subordinated note agreement (the "Second Convertible Note"), which was underwritten by the Company. The Second Convertible Note was issued in connection with the completion of the Talisman Energy Transaction and the related Equity Support Agreement. The Second Convertible Note contains terms comparable to the First Convertible Note. During June and July 2008, the Company sold $380,000 of the Second Convertible Note to other investors in Hallwood Energy. As of March 31, 2009, $9,300,000 principal amount of the Second Convertible Notes were outstanding, of which $8,920,000 was held by the Company and $380,000 was held by other Hallwood Energy investors.

Limited Partnership Interests. There are currently three classes of limited partnership interests held in Hallwood Energy:
• Class C interests bear a 16% priority return which compounds monthly. The priority return will be accrued and become payable when, as and if declared by the general partner of Hallwood Energy. The Class C interests receive priority on any distributions of cash or sales proceeds from a terminating capital transaction, as defined. The Class C capital contributions and unpaid priority returns totaled approximately $84,422,000 and $25,707,000, respectively, at March 31, 2009.

• Class A interests have certain voting rights and with the general partner would receive 100% of the distributions of available cash and net proceeds from a terminating capital transaction, as defined, subsequent to the payment of all unpaid Class C priority return and of all Class C capital contributions until the unrecovered capital accounts of each Class A partner interest is reduced to zero, and thereafter share in all future distributions of available cash and net proceeds from terminating capital transactions with the holders of the Class B interests.

• Class B interests represent vested net profit interests awarded to key individuals by Hallwood Energy. At March 31, 2009 and December 31, 2008, outstanding Class B interests had rights to receive 20.0% of distributions . . .