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HWG > SEC Filings for HWG > Form 10-Q on 14-Nov-2011All Recent SEC Filings

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Form 10-Q for HALLWOOD GROUP INC


14-Nov-2011

Quarterly Report


Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview
General. The Hallwood Group Incorporated (the "Company") operates as a holding company with its principal business in the textile products industry.
Textile Products. In 2010 and 2011, 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, costs, availability of supplies, its response to competition and its ability to generate new markets. Although the textile activities of the Company and its subsidiaries (collectively, the "Hallwood Group") have generated positive cash flow in recent years, there is no assurance that this trend will continue.
While Brookwood has enjoyed substantial revenues from 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 $21,802,000 and $52,212,000 for the 2011 third quarter and nine month periods, respectively, were 6.4% and 44.0% lower than the comparable periods in 2010 of $23,295,000 and $93,246,000. Orders for military goods in the 2010 fourth quarter and 2011 first quarter declined significantly, which affected the 2011 first quarter military sales. Brookwood received an increased level of military orders in late March and into the subsequent 2011 periods, however not to the same level as the first half of 2010.
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 recent years that include Brookwood's products, which resulted in substantial 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. 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 developed 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 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.
Investments in Financial Instruments. In the 2011 first quarter, the Company opened an investment account with UBS AG, a global financial services firm, and disclosed that it intended to transfer a significant portion of the cash it holds from time to time to the UBS account to be placed in various financial instruments and may borrow additional amounts from UBS to invest. As of November 14, 2011, no funds have been transferred into the UBS account. In connection with the litigation matters of Hallwood Energy, L.P. ("Hallwood Energy") discussed in Note 14, on July 25, 2011, the Court issued the Proposed Findings of Fact, Conclusions of Law and Judgment Awarding Various Monetary Damages (the "Proposed Findings") in the Adversary proceeding. The Court proposed that the

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

United States District Court award damages against the Company plus interest and attorney fees. The Company has filed its objections to the Proposed Findings in the United States District Court and will vigorously defend against the entry of any final judgment. Until this matter is concluded, the Company does not intend to pursue its previously announced intention to transfer funds into the UBS account.
The Company intended to place the amounts in the UBS account in various instruments, including equity and debt that is publicly traded or is issued by United States and foreign publicly traded companies, financial institutions, mutual funds and exchange traded funds. The Company does not intend to invest in instruments for which there is not a public market or not issued by publicly traded companies, financial institutions, mutual funds or exchange traded funds. The amounts invested will at all times remain in the Company's investment account and under its control, and will be invested for its own account.
The UBS account will be a margin account, under which the Company may borrow from UBS up to 70% (for equity) to 90% (for debt) of the loan value of investment securities held in the account at a current borrowing cost of 50 basis points over the interest rate applicable to dollar deposits in the London interbank market. All borrowings in the account will be secured by a pledge of all assets held in the account. If at any time the value of the assets in the account fall below the agreed margin, or if UBS should, for any other reason, consider the assets pledged as no longer adequate cover for its claims, the Company will be required, upon request by UBS, either to reduce the debt through repayments or to furnish sufficient additional security, so as to re-establish the required margin. If the Company fails to comply with this demand within such time limit as may be set by UBS at its discretion, the debt will become repayable and UBS will be allowed to sell the assets on the open market to pay the debt.
As noted above, until the Hallwood Energy litigation matter is concluded, the Company does not intend to pursue its previously announced intention to transfer funds into the UBS account.
Energy. Hallwood Energy was a privately held independent oil and gas limited partnership and operated as an upstream energy company engaged in the acquisition, development, exploration, production, and sale of hydrocarbons, with a primary focus on natural gas assets.
In March 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 were adjudicated 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 was only an investor in and creditor of Hallwood Energy. The bankruptcy filing did not include the Company or any other of its assets. In October 2009, the Bankruptcy Court confirmed the plan of reorganization of the debtors.
Refer to the section "Investments in Hallwood Energy" for a further description of the Company's former energy activities, including the bankruptcy case.
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 2011 third quarter of $350,000, compared to net income of $407,000 in 2010. Revenue for the 2011 third quarter was $37,649,000, compared to $36,771,000 in 2010.
The net loss for the 2011 nine month period was $4,173,000, compared to net income of $10,453,000 in 2010. Revenue for the 2011 nine month period was $101,117,000, compared to $131,848,000 in 2010.

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

Revenues
Textile products sales of $37,649,000 increased by $878,000, or 2.4%, in the 2011 third quarter, compared to $36,771,000 in 2010. Sales for the 2011 nine month period decreased by $30,731,000, or 23.3%, to $101,117,000, compared to $131,848,000 in 2010. The fluctuations in the 2011 periods were principally due to a decrease in sales of specialty fabric to U.S. military contractors as a result of decreases in orders from the military to Brookwood's customers, partially offset by increased sales in its other market segments. Military sales accounted for $21,802,000 and $52,212,000 in the 2011 third quarter and nine month periods, respectively, compared to $23,295,000 and $93,246,000 in 2010. The military sales represented 57.9% and 63.4% of Brookwood's net sales in the 2011 and 2010 third quarters, respectively, and 51.6% and 70.7% in the 2011 and 2010 nine month periods, respectively. Generally, military sales represent sales of a product to a customer (prime and sub-prime contractors) that will be incorporated into an end product that will be used to fulfill a U.S. or international military contract.
Sales Concentration. Brookwood has two customers who accounted for more than 10% of Brookwood's sales. Sales to one Brookwood customer, Tennier Industries, Inc. ("Tennier"), accounted for more than 10% of Brookwood's sales during both the 2011 and 2010 periods. Brookwood's relationship with Tennier is ongoing. Sales to Tennier, which are included in military sales, were $5,061,000 and $11,456,000 in the 2011 third quarter and nine month periods, respectively, compared to $8,296,000 and $44,064,000 in 2010. Sales to Tennier represented 13.4% and 22.6% of Brookwood's net sales in the 2011 and 2010 third quarters, respectively, and 11.3% and 33.4% in the 2011 and 2010 nine month periods, respectively. Sales to another customer, ORC Industries, Inc. ("ORC"), accounted for more than 10% of Brookwood's sales in 2010. Brookwood's relationship with ORC is ongoing. Sales to ORC, which are included in military sales, were $867,000 and $1,958,000 in the 2011 third quarter and nine month periods, respectively, compared to $2,583,000 and $12,662,000 in 2010. Sales to ORC represented 2.3% and 7.0% of Brookwood's net sales in the 2011 and 2010 third quarters, respectively, and 1.9% and 9.6% in the 2011 and 2010 nine month periods, respectively.
Orders for military goods in the 2010 fourth quarter and 2011 first quarter declined significantly, which affected the 2011 first quarter military sales. Brookwood received an increased level of military orders in late March and into the subsequent 2011 periods, however, not to the same level as the first half of 2010.
Expenses
Textile products cost of sales of $30,116,000 for the 2011 third quarter increased by $1,662,000, or 5.8%, compared to $28,454,000 in 2010. For the nine month periods, textile products cost of sales of $82,426,000 for 2011 decreased by $13,072,000, or 13.7%, compared to $95,498,000 in 2010. The 2011 fluctuations principally resulted from material and labor costs associated with the lower sales volume for the military segment, and from changes in product mix, offset by an increase in royalty expense related to certain military products. Cost of sales includes all costs associated with the manufacturing process, including but not limited to, materials, labor, utilities, royalties, 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. 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 decreased for the 2011 third quarter, 20.0% versus 22.6%, and for the 2011 nine month period, 18.5% versus 27.6%. The lower gross profit margin was attributed to lower military sales volume and changes in product mix.
Administrative and selling expenses were comprised of the following (in thousands):

                                 Three Months Ended          Nine Months Ended
                                    September 30,              September 30,
                                  2011          2010         2011          2010
            Textile products   $    5,113      $ 4,253     $  13,244     $ 13,285
            Corporate               1,768        3,108         4,114        6,351


            Total              $    6,881      $ 7,361     $  17,358     $ 19,636

Textile products administrative and selling expenses of $5,113,000 for the 2011 third quarter increased by $860,000, or 20.2%, from 2010. For the 2011 nine months, selling and administrative expenses decreased by $41,000, or 0.3%, compared to 2010. The increase for the 2011 third quarter from the 2010 quarter was primarily attributable to an increase in professional services of $1,380,000, principally legal fees, partially offset by a decrease of $494,000 related to performance and other related payroll costs.

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

The decrease for the 2011 nine month period was primarily attributable to a decrease of $1,088,000 related to performance and other related payroll costs, and reduced factor commissions of $137,000 and was partially offset by an increase in professional services of $1,487,000, principally legal fees and an increase in employee related expenses of $156,000.
The textile products administrative and selling expenses included items such as payroll, professional fees, sales commissions, factor commissions, marketing, rent, insurance and travel. Brookwood conducts research and development activities related to the exploration, development and production of innovative products and technologies. Research and development costs were approximately $149,000 and $486,000 for the three months and nine months ended September 30, 2011, compared to $165,000 and $598,000 for the three months and nine months ended September 30, 2010, respectively.
Corporate administrative expenses decreased $1,340,000, or 43.1%, for the 2011 third quarter, compared to 2010. For the 2011 nine months, corporate expenses decreased $2,237,000, or 35.2%, compared to 2010. The decreases were principally attributable to a decrease in professional fees of $1,344,000 for the 2011 three month period and $2,330,000 for the 2011 nine month period, respectively. The decline in professional fees is principally attributable to the December 2010 conclusion of the trial in the Adversary proceeding and the reimbursement of previously expensed legal fees from the insurance carrier for the Company's directors' and officers' liability insurance policy for costs related to the Hallwood Energy litigation matters.
In connection with the Hallwood Energy litigation matters discussed in Note 14, on July 25, 2011, the bankruptcy court issued Proposed Findings in the Adversary proceedings. The court proposed that the United States District Court award damages against the Company totaling approximately $18,700,000 plus prejudgment and post judgment interest and attorneys' fees as may be requested and awarded pursuant to a subsequent motion. The Proposed Findings (including the awards) are not final. The Company and each of the other parties has objected to various aspects of the Proposed Findings to the United States District Court, which will review the portions to which objections have been raised on a de novo basis. The Company intends to vigorously defend against the entry of any final judgment.
As a result of the Proposed Findings, the Company believes that for accounting purposes it is probable that a liability has been incurred and that an estimate of the amount of the loss for accounting purposes may be made. Accordingly, taking into consideration the Company's objections to the Proposed Findings, the Company reserved $7,500,000 at June 30, 2011. The Company does not believe a change to the reserve is necessary at September 30, 2011. This noncash, accrued reserve of $7,500,000 is reported in the Company's balance sheet under "Hallwood Energy matters - Litigation reserve", in addition to the $3,201,000 that was previously recorded in connection with the Equity Support Agreement, for a total reserve of $10,701,000 at September 30, 2011. This reserve amount has been established in consultation with the Company's litigation counsel in the Hallwood Energy litigation, based on their best judgment of the probabilities of success related to, among other factors, the objections filed by the Company and the adverse parties. However, the actual results of litigation cannot be predicted with any certainty and the amount of liability to the Company may exceed any estimates or reserves.
Other Income (Loss)
Interest expense was $25,000 and $74,000 in the 2011 third quarter and nine month periods, respectively, compared to $89,000 and $207,000 in the 2010 periods. Interest expense principally relates to Brookwood's revolving credit facility in an amount up to $25,000,000 with KeyBanc (the "Working Capital Revolving Credit Facility"). The decreases in interest expense were due to a decline in the average outstanding loan amount and lower interest rates.
Interest and other income was $5,000 and $35,000 in the 2011 third quarter and nine month periods, respectively, compared to $2,000 and $8,000 in 2010. The 2011 increases were principally due to interest earned on short-term investments.

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                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 (in thousands):

                              Three Months Ended           Nine Months Ended
                                 September 30,               September 30,
                             2011            2010           2011         2010
               Federal
               Current     $     208       $     152     $      398     $ 5,157
               Deferred          (13 )           174         (2,638 )       174

               Sub-total         195             326         (2,240 )     5,331

               State
               Current            87             136            207         731
               Deferred            -               -              -           -

               Sub-total          87             136            207         731


               Total       $     282       $     462     $   (2,033 )   $ 6,062

At September 30, 2011, the net deferred tax asset was attributable to temporary differences that upon reversal, could be utilized to offset income from operations. The statutory federal tax rate in both periods was 35%, 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
Hallwood Energy was a privately held independent oil and gas limited partnership and operated as an upstream energy company engaged in the acquisition, development, exploration, production, and sale of hydrocarbons, with a primary focus on natural gas assets.
Prior to the confirmation of Hallwood Energy's plan of reorganization by Hallwood Energy (discussed below) in October 2009, the Company had invested $61,481,000 in Hallwood Energy's general partnership interest and Class A and Class C limited partnership interests. In addition, the Company loaned Hallwood Energy $13,920,000 in the form of convertible notes issued by Hallwood Energy. The Company accounted for the investment in Hallwood Energy using the equity method of accounting and recorded its pro rata share of Hallwood Energy's net income (loss), partners' capital transactions, and comprehensive income (loss), as appropriate. In connection with Hallwood Energy's bankruptcy reorganization, the Company's general and limited partnership interests in Hallwood Energy were extinguished and the Company no longer accounts for the investment in Hallwood Energy using the equity method of accounting. Certain of the Company's officers and directors were investors in Hallwood Energy. In addition, as a member of management of Hallwood Energy, one officer of the Company held a profit interest in Hallwood Energy that was also extinguished in the bankruptcy.
Bankruptcy Reorganization by Hallwood Energy. In March 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 were adjudicated 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 was only an investor in and creditor of Hallwood Energy. The bankruptcy filing did not include the Company or any other of its assets.
In October 2009, the Bankruptcy Court confirmed a plan of reorganization of the debtors that, among other things, extinguished Hallwood Energy's general partnership and limited partnership interests, including those held by the Company. In addition, Hallwood Energy's convertible notes, including those held by the Company, are subordinated to recovery in favor of Hall Phoenix/Inwood, Ltd. ("HPI"), the secured lender to Hallwood Energy. As a result of these developments, the Company does not anticipate that it will recover any of its investments in Hallwood Energy.
Litigation. In connection with Hallwood Energy's bankruptcy proceeding, Hallwood Energy and other parties have filed lawsuits and threatened to assert additional claims against the Company and certain related parties alleging actual, compensatory and exemplary damages in excess of $200,000,000, based on purported breach of contract, fraud, breach of fiduciary duties, neglect, negligence and various misleading statements, omissions and misrepresentations. See Note 14 to the condensed consolidated financial statements of this report.

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

In one of these matters, the court has issued the Proposed Findings proposing that damages be awarded against the Company totaling approximately $18,700,000 plus prejudgment and postjudgment interest and attorney's fees as may be requested and awarded pursuant to a subsequent motion. The Proposed Findings (including the awards) are not final. As a result of the Proposed Findings, the Company has reserved $7,500,000 on its balance sheet as a noncash accrual under Hallwood Energy matters - Litigation Reserve, in addition to the $3,200,000 that was previously recorded in connection with the Equity Support Agreement.
Critical Accounting Policies
There have been no changes to the critical accounting policies identified and set forth in the Company's annual report on Form 10-K for the year ended December 31, 2010.
Related Party Transactions
Hallwood Investments Limited. The Company has entered into a financial consulting contract with Hallwood Investments Limited (AHIL"), a corporation associated with Mr. Anthony J. Gumbiner, the Company's chairman and principal stockholder. The contract provides for HIL to furnish and perform international consulting and advisory services to the Company and its subsidiaries, including strategic planning and merger activities, for annual compensation of $996,000. The annual amount is payable in monthly installments. The contract automatically renews for one-year periods if not terminated by the parties beforehand. Additionally, HIL and Mr. Gumbiner are also eligible for bonuses from the Company or its subsidiaries, subject to approval by the Company's or its subsidiaries' board of directors. The Company also reimburses HIL for reasonable expenses in providing office space and administrative services in Europe in connection with HIL's services to the Company pursuant to the financial consulting contract and for travel and related expenses between Europe and the Company's locations in the United States and health insurance premiums.
A summary of the fees and expenses related to HIL and Mr. Gumbiner are detailed below (in thousands):

                                                  Three Months Ended                 Nine Months Ended
                                                     September 30,                     September 30,
                                                2011              2010              2011            2010
Consulting fees                               $     249         $     249        $      747        $   747
Office space and administrative services             71                62               238            192
Travel and other expenses                            71                20               151            110

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