Overview
General. The Company currently operates as a holding company with interests in textiles 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 $32,036,000 and $60,430,000 for the 2009 second quarter and six month periods, respectively, were 0.2% and 0.5% higher than the comparable periods in 2008 of $31,981,000 and $60,139,000.
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. A provision of U.S. federal law, known as the Berry Amendment, generally requires the Department of Defense to give preference in procurement to domestically produced products, including textiles. Brookwood's sales of products to the U.S. military market is highly dependent upon the continuing application and enforcement of the Berry Amendment by the U.S. government. 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.
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 investments.
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 2009 second quarter of $3,569,000, compared to a net loss of $1,330,000 in 2008. Revenue for the 2009 second quarter was $44,317,000, compared to $47,134,000 in 2008.
Net income for the 2009 six month period was $6,523,000, compared to net income of $236,000 in 2008. Revenue for the 2009 six month period was $83,984,000, compared to $91,121,000 in 2008.
Revenues
Textile products sales of $44,317,000 decreased by $2,817,000, or 6.0%, in the 2009 second quarter, compared to $47,134,000 in 2008. Sales for the 2009 six month period decreased by $7,137,000, or 7.8%, to $83,984,000, compared to $91,121,000 in 2008. The decreases in the 2009 periods were principally due to a decrease in the commercial market segment, as well as sail cloth, flag and other customer products affected by the current economic downturn. Sales of specialty fabric to U.S. military contractors were stable. Military sales accounted for $32,036,000 and $60,430,000 in the 2009 second quarter and six month periods, respectively, compared to $31,981,000 and $60,139,000 in 2008. The military sales represented 72.3% and 67.9% of Brookwood's net sales in the 2009 and 2008 second quarters, respectively, and 72.0% and 66.0% in the 2009 and 2008 six month periods, respectively.
Sales Concentration. 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 $11,491,000 and $23,365,000 in the 2009 second quarter and six month periods, respectively, compared to $15,112,000 and $29,980,000 in 2008. Sales to Tennier represented 25.9% and 32.1% of Brookwood's net sales in the 2009 and 2008 second quarters, respectively, and 27.8% and 32.9% in the 2009 and 2008 six month periods, respectively. Sales to another customer, ORC Industries, Inc. ("ORC"), accounted for more than 10% of Brookwood's sales in 2009 and 2008. Its relationship with ORC is ongoing. Sales to ORC, which are included in military sales, were $8,328,000 and $14,999,000 in the 2009 second quarter and six month periods, respectively, compared to $5,252,000 and $9,281,000 in 2008. Sales to ORC represented 18.8% and 11.1% of Brookwood's net sales in the 2009 and 2008 second quarters, respectively, and 17.9% and 10.2% in the 2009 and 2008 six month periods, respectively. Sales to another customer accounted for 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 the military sales, were $3,316,000 and $6,160,000 in the 2009 second quarter and six month periods, compared to $6,114,000 and $10,769,000 in the 2008 second quarter and six month periods, which represented 7.5% and 13.0% of Brookwood sales second quarters in the 2009 and 2008, and 7.3% and 11.8% in the 2009 and 2008 six month periods, respectively.

Expenses
Textile products cost of sales of $32,103,000 for the 2009 second quarter decreased by $1,864,000, or 5.5%, compared to $33,967,000 in 2008. For the six month periods, textile products cost of sales of $61,506,000 for 2009 decreased by $5,013,000, or 7.5%, compared to $66,519,000 in 2008. The 2009 decreases principally resulted from reduced sales volume, changes in product mix and reduced energy costs, which decreased 31.4% and 26.2% in the 2009 second quarter and six month periods compared to the 2008 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 gross profit margin for the 2009 second quarter, 27.6% versus 27.9%, and for the 2009 six month period, 26.8% versus 27.0%, declined slightly. Declines in the gross profit margin related to lower sales volumes were offset by improved margins attributable to changes in product mix, energy savings and manufacturing efficiencies such as reductions to material working loss.
Administrative and selling expenses were comprised of the following (in thousands):

                                  Three Months Ended          Six Months Ended
                                       June 30,                   June 30,
                                   2009          2008         2009         2008

             Textile products   $    4,475      $ 4,428     $  8,880     $  8,461
             Corporate               1,908        1,125        2,987        2,305


             Total              $    6,383      $ 5,553     $ 11,867     $ 10,766

Textile products administrative and selling expenses of $4,475,000 for the 2009 second quarter increased by $47,000, or 1.1%, from 2008. For the six months, selling and administrative expenses increased by $419,000, or 5.0%, compared to 2008. The increase for the 2009 second quarter from the 2008 quarter was primarily attributable to an increase of $116,000 in bad debt reserve costs. The increase for the 2009 six month period was primarily attributable to an increase of $520,000 in professional services, principally legal fees, $157,000 of employee related expenses (e.g. salaries and benefits) and $107,000 in increased bad debt reserve costs and was partially offset by reduced costs of $437,000 related to performance and other related payroll costs. 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 $188,000 and $413,000 for the three months and six months ended June 30, 2009 and $206,000 and $459,000 for the three months and six months ended June 30, 2008, respectively.
Corporate administrative expenses increased $783,000, or 69.6%, for the 2009 second quarter, compared to 2008. For the six months, corporate expenses increased $682,000, or 29.6%, compared to 2008. The increases were principally attributable to higher professional fees of $908,000 and $968,000 for the 2009 three month and six month periods, respectively, including costs related to the Hallwood Energy bankruptcy, the special committee's activities in considering the offer by the chairman and principal stockholder to acquire the Company's outstanding common stock that has been canceled and accounting and tax services. The increases were partially offset by decreased employee related expenses of $80,000 and $150,000 for the 2009 three month and six month periods, respectively, due to a reduction in staff.

Other Income (Loss)
Equity loss from the Company's investments in Hallwood Energy, attributable to the Company's 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 second quarter, compared to $9,159,000 in 2008. The equity loss for the 2009 six month period was zero, compared to $12,120,000 in 2008. In consideration of Hallwood Energy's ongoing bankruptcy proceedings, the anticipated extinguishment of the Company's ownership interest in Hallwood Energy in the proposed plan of reorganization, the previously recorded reduction in the carrying value of the Hallwood Energy investment to zero and HPI's possession of substantially all of Hallwood Energy's assets and operations (including all financial records), the Company is unable to provide operating data for Hallwood Energy for the three months and six month periods ended June 30, 2009. In the 2008 second quarter, Hallwood Energy reported a loss of $11,600,000, which included a noncash expense of $14,292,000 attributable to the potential make-whole fee that would be payable upon any future prepayment of notes payable that were amended in connection with the Talisman Energy Transaction. For the 2008 six month period, Hallwood Energy reported a loss of $21,888,000. The Company recorded equity losses in the 2008 periods to the extent of loans it made to Hallwood Energy in 2008 of $4,830,000 and a commitment to invest additional funds in accordance with the Equity Support Agreement up to $7,290,000 and maintained the carrying value of its investment in Hallwood Energy at zero.
Interest expense was $55,000 and $127,000 in the 2009 second quarter and six month periods, respectively, compared to $181,000 and $428,000 in the 2008 periods. Interest expense principally relates to Brookwood's Key Bank revolving credit facility. The decreases in interest expense were due to a decline in the average outstanding loan amount and lower average interest rates (1.82% and 4.37% at June 30, 2009 and 2008, respectively).
Interest and other income was $6,000 and $17,000 in the 2009 second quarter and six month periods, respectively, compared to $24,000 and $42,000 in 2008. The 2009 decreases were principally due to reduced interest income earned on lower balances of cash and cash equivalents and lower interest rates.
Income Taxes
Following is a schedule of income tax expense (benefit) (in thousands):

                              Three Months Ended          Six Months Ended
                                   June 30,                   June 30,
                               2009           2008        2009         2008

                Federal
                Deferred    $    1,776       $ (686 )   $   3,298     $   121
                Current             62            -            62           -

                Sub-total        1,838         (686 )       3,360         121

                State
                Deferred             -            -             -           -
                Current            375          314           618         973

                Sub-total          375          314           618         973


                Total       $    2,213       $ (372 )   $   3,978     $ 1,094

At June 30, 2009, the net deferred tax asset was attributable to temporary differences. 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 June 30, 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.

Certain of the Company's officers and directors are investors in Hallwood Energy. In addition, one officer of the Company holds a profit interest in Hallwood Energy.
Bankruptcy Filing 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 currently 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.
On June 29, 2009, the Bankruptcy Court granted a motion by Hall Phoenix/Inwood, Ltd. ("HPI"), the secured lender to Hallwood Energy, to partially lift the automatic stay applicable in bankruptcy proceedings, permitting HPI, among other things, to enter upon and take possession of substantially all of Hallwood Energy's assets and operations.
Hallwood Energy's previously filed adversary proceeding against the Company requesting that the Company fund $3,200,000 under the Equity Support Agreement (discussed below) between Hallwood Energy and the Company remains outstanding. In addition, the Bankruptcy Court had previously granted the motions of HPI and of FEI Shale, L.P. ("FEI"), a subsidiary of Talisman Energy, Inc., to intervene as plaintiffs in the proceeding. HPI and FEI contend that the Company's failure to fund $3,200,000 under an Equity Support Agreement damaged Hallwood Energy in an amount excess of $3,200,000 and have asserted compensatory and exemplary damages. HPI filed a motion for summary judgment on its claims and a hearing on this motion was held on July 17, 2009. The Court has not yet entered a ruling on the motion.
Subsequently, HPI has proposed a plan of reorganization that, among other things, would extinguish Hallwood Energy's general partnership and limited partnership interests, including those held by the Company. As a result of these developments, the Company does not anticipate that it will recover any of its investments in Hallwood Energy. The carrying value of the Company's investment in Hallwood Energy has been reflected as zero since December 31, 2007.
On August 3, 2009, the Company was served with a complaint in Hall Phoenix/Inwood Ltd. and Hall Performance Energy Partners 4, Ltd. v. The Hallwood Group Incorporated, et al. filed in the 298th District of Texas, No. 09-09551. The other defendants include Anthony J. Gumbiner, the Chairman and Chief Executive Officer of the Company, Bill Guzzetti, the President of the Company, certain affiliates of Mr. Gumbiner and certain officers of Hallwood Energy. The complaint alleges that the defendants defrauded plaintiffs in connection with plaintiffs acquiring interests in and providing loans to Hallwood Energy and seeks unspecified actual and exemplary damages.
In addition, in the Hallwood Energy bankruptcy proceeding, HPI has filed a disclosure statement alleging that it believes it has and, if its proposed plan of reorganization is approved, intends to pursue various claims against the Company and its officers, directors and affiliates and Hallwood Energy's officers and directors. Attorneys for HPI have also delivered a letter on behalf of HPI and certain affiliates alleging claims against the Company and its officers, directors and affiliates and Hallwood Energy's officers and directors for, among other things, breach of contract, breach of fiduciary duties, neglect, negligence, and various alleged misleading statements, omissions and misrepresentations. HPI and certain of its affiliates have asserted that its damages exceed $200,000,000. The Company believes that the allegations and claims are without merit and intends to defend the lawsuit and any future claims vigorously.
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 referred to in Note 4 to the condensed consolidated financial statements, 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 Hallwood Energy's Second Convertible Note. 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 were 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. Subject to certain defenses raised by the Company, the remaining commitment amount under the Equity Support Agreement was $3,200,000 at June 30, 2009. As further discussed in the litigation section below, Hallwood Energy has filed an adversary proceeding against the Company requesting that the Company's fund the additional $3,200,000.
The Company's carrying value of its Hallwood Energy investment, which was zero at December 31, 2008 and 2007, remained at zero as of June 30, 2009.
If the plan of reorganization proposed by HPI is approved by the Bankruptcy Court, it is anticipated that the Company's ownership interest in Hallwood Energy would be extinguished and the Company would no longer account for its investment in Hallwood Energy using the equity method of accounting. The Company's proportionate share of Hallwood Energy's accumulated losses that have not been recognized as of March 31, 2009 was approximately $12,892,000, based upon its 25% Class A limited partner ownership percentage. The Company's proportionate share of losses after March 31, 2009 is not determinable.
Litigation. As of February 25, 2009, the Company had contributed $9,300,000 to Hallwood Energy pursuant to the Equity Support Agreement discussed above. On that date, Hallwood Energy requested that the Company fund the additional $3,200,000, which the Company has not done. As previously discussed, on March 1, 2009, Hallwood Energy and its subsidiaries filed petitions for relief under Chapter 11 of the United States Bankruptcy Code. On March 30, 2009, Hallwood Energy filed an adversary proceeding against the Company requesting that the Company fund the additional $3,200,000. The case is Hallwood Energy, L.P. v. The Hallwood Group Incorporated, Adversary No. 09-03082, in the United States Bankruptcy Court for the Northern District of Texas, Dallas Division. On . . .