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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
____________________
FORM 10-Q
MARK ONE
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ____________
FOR THE PERIOD ENDED SEPTEMBER 30, 2003 COMMISSION FILE NUMBER: 1-8303
________________________________
THE HALLWOOD GROUP INCORPORATED
(Exact name of registrant as specified in its charter)
________________________________
DELAWARE 51-0261339
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
3710 RAWLINS, SUITE 1500
DALLAS, TEXAS 75219
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (214) 528-5588
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF CLASS ON WHICH REGISTERED
-------------- -----------------------
Common Stock ($0.10 par value) American Stock Exchange
10% Collateralized Subordinated Debentures New York Stock Exchange
Due July 31, 2005
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
TITLE OF CLASS
--------------
Series B Redeemable Preferred Stock
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12B-2 of the Act). YES [ ] NO [X]
1,326,343 shares of Common Stock, $.10 par value per share, were
outstanding at October 31, 2003.
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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
TABLE OF CONTENTS
ITEM NO. PART I - FINANCIAL INFORMATION PAGE
-------- ------------------------------ ----
1 Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets as of September 30, 2003
and December 31, 2002........................................... 3
Condensed Consolidated Statements of Income for the
Nine Months Ended September 30, 2003 and 2002................... 5
Condensed Consolidated Statements of Income for the
Three Months Ended September 30, 2003 and 2002.................. 7
Condensed Consolidated Statements of Comprehensive Income for the
Three Months Ended September 30, 2003 and 2002 and
Nine Months Ended September 30, 2003 and 2002................... 9
Condensed Consolidated Statements of Changes in Stockholders'
Equity for the Nine Months Ended September 30, 2003 ............ 10
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2003 and 2002................... 11
Notes to Condensed Consolidated Financial Statements................ 12
2 Management's Discussion and Analysis of
Financial Condition and Results of Operations....................... 26
3 Quantitative and Qualitative Disclosures about Market Risk.............. 38
4 Controls and Procedures and Internal Controls........................... 38
PART II - OTHER INFORMATION
---------------------------
1 to 6 Other Information, Exhibits and Reports on Form 8-K..................... 39
Signature Page.......................................................... 41
Index to Exhibits....................................................... 42
Page 2
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
ASSETS
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
REAL ESTATE
Investments in HRP ............................. $15,871 $13,525
Receivables and other assets
Related parties ............................. 318 732
Other ....................................... 27 60
------- -------
16,216 14,317
TEXTILE PRODUCTS
Inventories .................................... 22,263 18,913
Receivables .................................... 20,345 15,743
Property, plant and equipment, net ............. 9,340 9,315
Prepaids, deposits and other assets ............ 379 548
------- -------
52,327 44,519
OTHER
Deferred tax asset, net ........................ 9,346 4,221
Investment in HEC .............................. 4,563 3,313
Cash and cash equivalents ...................... 1,735 1,377
Prepaids, deposits and other assets
Other ....................................... 339 317
Related parties ............................. 186 140
Hotel assets held for use ...................... 313 362
Restricted cash ................................ -- 982
------- -------
16,482 10,712
------- -------
TOTAL ....................................... $85,025 $69,548
======= =======
See accompanying notes to condensed consolidated financial statements.
Page 3
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
REAL ESTATE
Accounts payable and accrued expenses ............................... $ 134 $ 1,306
TEXTILE PRODUCTS
Accounts payable and accrued expenses ............................... 15,871 10,803
Loans payable ....................................................... 13,112 13,247
-------- --------
28,983 24,050
OTHER
Loans payable ....................................................... 9,584 2,817
10% Collateralized Subordinated Debentures .......................... 6,583 6,625
Separation Agreement obligations .................................... 3,625 4,000
Interest, litigation and other accrued expenses
Related party .................................................... 1,796 --
Other ............................................................ 561 1,274
Deferred revenue - noncompetition agreement ......................... 1,611 3,424
Hotel accounts payable and accrued expenses ......................... 1,077 850
Redeemable preferred stock, Series B ................................ 1,000 1,000
Capital lease obligations ........................................... 649 1,066
-------- --------
26,486 21,056
TOTAL LIABILITIES ................................................ 55,603 46,412
STOCKHOLDERS' EQUITY
Preferred stock, 250,000 shares issued and outstanding as Series B .. -- --
Common stock, issued 2,396,103 shares at both dates; outstanding
1,326,343 and 1,361,343 shares, respectively ..................... 240 240
Additional paid-in capital .......................................... 54,429 54,452
Accumulated deficit ................................................. (9,463) (16,417)
Accumulated other comprehensive income .............................. 150 191
Treasury stock, 1,069,760 and 1,034,760 shares, respectively; at cost (15,934) (15,330)
-------- --------
TOTAL STOCKHOLDERS' EQUITY ....................................... 29,422 23,136
-------- --------
TOTAL ............................................................ $ 85,025 $ 69,548
======== ========
See accompanying notes to condensed consolidated financial statements.
Page 4
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------
2003 2002
-------- --------
REAL ESTATE
Fees
Related parties ........................................ $ 3,425 $ 3,838
Other .................................................. 148 176
Equity income (loss) from investments in HRP .............. (232) 1,325
-------- --------
3,341 5,339
Litigation expense ........................................ 3,647 --
Administrative expenses ................................... 839 1,000
Amortization .............................................. 504 504
-------- --------
4,990 1,504
-------- --------
Income (loss) from real estate operations .............. (1,649) 3,835
TEXTILE PRODUCTS
Sales
Trade .................................................. 75,239 49,914
Related party .......................................... -- 11,621
Equity income from investment in joint venture ............ -- 1,157
-------- --------
75,239 62,692
Cost of sales ............................................. 59,381 52,120
Administrative and selling expenses ....................... 10,579 8,129
Interest .................................................. 496 554
-------- --------
70,456 60,803
-------- --------
Income from textile products operations ................ 4,783 1,889
OTHER
Amortization of deferred revenue - noncompetition agreement 1,813 1,813
Hotel revenue ............................................. 1,058 1,290
Equity income (loss) from investment in HEC ............... 199 (121)
Interest and other income ................................. 4 316
-------- --------
3,074 3,298
Administrative expenses ................................... 1,457 1,390
Hotel expenses ............................................ 1,437 1,379
Interest expense .......................................... 662 637
-------- --------
3,556 3,406
-------- --------
Other (loss) ........................................... (482) (108)
-------- --------
Income from continuing operations before income taxes .. 2,652 5,616
Income tax benefit (expense) ........................... 4,352 (1,860)
-------- --------
Income from continuing operations ...................... 7,004 3,756
See accompanying notes to condensed consolidated financial statements.
Page 5
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------
2003 2002
------- -------
Income from discontinued hotel operations, net of tax .............. $ -- $ 3,719
------- -------
Income before cumulative effect of change in accounting principle 7,004 7,475
Income from cumulative effect of change in accounting principle .... -- 568
------- -------
NET INCOME ............................................................ 7,004 8,043
Preferred stock dividend ........................................... (50) (50)
------- -------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS ........................... $ 6,954 $ 7,993
======= =======
INCOME PER COMMON SHARE
BASIC
Income from continuing operations after preferred dividend ...... $ 5.13 $ 2.72
Income from discontinued operations ............................. -- 2.73
Income from cumulative effect of change in accounting principle . -- 0.42
------- -------
Net income available to common stockholders .................. $ 5.13 $ 5.87
======= =======
ASSUMING DILUTION
Income from continuing operations after preferred dividend ...... $ 5.02 $ 2.61
Income from discontinued operations ............................. -- 2.59
Income from cumulative effect of change in accounting principle . -- 0.40
------- -------
Net income available to common stockholders .................. $ 5.02 $ 5.60
======= =======
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic .............................................................. 1,354 1,361
======= =======
Assuming dilution .................................................. 1,386 1,433
======= =======
See accompanying notes to condensed consolidated financial statements.
Page 6
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2003 2002
-------- --------
REAL ESTATE
Fees
Related parties ........................................ $ 1,137 $ 1,460
Other .................................................. 38 72
Equity income from investments in HRP ..................... 115 378
-------- --------
1,290 1,910
Administrative expenses ................................... 301 433
Amortization .............................................. 168 168
Litigation expense ........................................ 45 --
-------- --------
514 601
-------- --------
Income from real estate operations ..................... 776 1,309
TEXTILE PRODUCTS
Sales
Trade .................................................. 26,174 15,143
Related party .......................................... -- 2,640
Equity income from investment in joint venture ............ -- 434
-------- --------
26,174 18,217
Cost of sales ............................................. 20,298 14,916
Administrative and selling expenses ....................... 3,510 2,515
Interest .................................................. 164 180
-------- --------
23,972 17,611
-------- --------
Income from textile products operations ................ 2,202 606
OTHER
Amortization of deferred revenue - noncompetition agreement 605 605
Hotel revenue ............................................. 354 392
Equity income (loss) from investment in HEC ............... 92 (44)
Interest and other income ................................. 2 8
-------- --------
1,053 961
Hotel expenses ............................................ 518 449
Administrative expenses ................................... 508 416
Interest expense .......................................... 239 207
-------- --------
1,265 1,072
-------- --------
Other (loss) ........................................... (212) (111)
-------- --------
Income from continuing operations before income taxes .. 2,766 1,804
Income tax benefit (expense) ........................... 2,054 (506)
-------- --------
Income from continuing operations ...................... 4,820 1,298
See accompanying notes to condensed consolidated financial statements.
Page 7
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2003 2002
------- --------
Loss from discontinued hotel operations, net of tax $ -- $ (15)
------- -------
NET INCOME ............................................ 4,820 1,283
Preferred stock dividend ........................... -- --
------- -------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS ........... $ 4,820 $ 1,283
======= =======
INCOME PER COMMON SHARE
BASIC
Income from continuing operations ............... $ 3.60 $ 0.95
Loss from discontinued operations ............... -- (0.01)
------- -------
Net income available to common stockholders .. $ 3.60 $ 0.94
======= =======
ASSUMING DILUTION
Income from continuing operations ............... $ 3.44 $ 0.95
Loss from discontinued operations ............... -- (0.01)
------- -------
Net income available to common stockholders .. $ 3.44 $ 0.94
======= =======
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic .............................................. 1,340 1,361
======= =======
Assuming dilution .................................. 1,401 1,361
======= =======
See accompanying notes to condensed consolidated financial statements.
Page 8
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ ------------------
2003 2002 2003 2002
------- ------- ------- -------
NET INCOME ............................. $ 4,820 $ 1,283 $ 7,004 $ 8,043
Other Comprehensive Income (Loss)
Pro rata share of other comprehensive
loss from equity investments in HRP
Amortization of interest rate swap (14) (15) (41) (44)
------- ------- ------- -------
COMPREHENSIVE INCOME ................... $ 4,806 $ 1,268 $ 6,963 $ 7,999
======= ======= ======= =======
See accompanying notes to condensed consolidated financial statements.
Page 9
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS)
(UNAUDITED)
ACCUMULATED
COMMON STOCK ADDITIONAL OTHER TREASURY STOCK TOTAL
------------------ PAID-IN ACCUMULATED COMPREHENSIVE ----------------- STOCKHOLDERS'
SHARES PAR VALUE CAPITAL DEFICIT INCOME SHARES COST EQUITY
------ --------- ---------- ----------- ------------- ------ -------- -------------
BALANCE, JANUARY 1, 2003.............. 2,396 $ 240 $ 54,452 $(16,417) $ 191 1,035 $(15,330) $ 23,136
Net income......................... 7,004 7,004
Purchase of treasury stock......... 35 (604) (604)
Pro rata share of partners'
capital transactions from
equity investments in HRP:
Exercise of stock options....... (23) (23)
Amortization of interest rate
swap......................... (41) (41)
Cash dividend on preferred stock... (50) (50)
----- ------ -------- -------- ------ ----- -------- --------
BALANCE, SEPTEMBER 30, 2003........... 2,396 $ 240 $ 54,429 $ (9,463) $ 150 1,070 $(15,934) $ 29,422
===== ====== ======== ======== ====== ===== ======== ========
See accompanying notes to condensed consolidated financial statements.
Page 10
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------
2003 2002
------- -------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income ........................................................ $ 7,004 $ 8,043
Adjustments to reconcile net income to net cash provided by
operating activities:
Deferred tax expense (benefit) ................................. (5,125) 1,476
Amortization of deferred revenue - noncompetition agreement .... (1,813) (1,813)
Accrued litigation expense ..................................... 1,636 --
Depreciation and amortization .................................. 1,629 1,523
Decrease in restricted cash .................................... 982 --
Equity income/loss from investments in HRP ..................... 232 (1,325)
Equity income/loss from investment in HEC ...................... (199) 121
Amortization of deferred gain from debenture exchange .......... (42) (38)
Equity income from textile products joint venture .............. -- (1,157)
Income from cumulative effect of changes in accounting principle -- (568)
Net change in textile products assets and liabilities .......... (2,715) 670
Net change in other assets and liabilities ..................... (947) (939)
Discontinued operations:
Net change in other hotel assets and liabilities ............ (400) 235
Gain from extinguishment of hotel debt ...................... -- (5,789)
Deferred tax expense ........................................ -- 1,800
------- -------
Net cash provided by operating activities ................... 242 2,239
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in HRP limited partnership units ....................... (2,988) --
Investment in HEC common stock .................................... (1,051) (2,500)
Investments in textile products property and equipment ............ (1,067) (705)
Investment in hotel held for use .................................. -- (18)
------- -------
Net cash (used in) investing activities ..................... (5,106) (3,223)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from bank borrowings and loans payable ................... 7,772 3,542
Repayment of bank borrowings and loans payable .................... (1,807) (4,263)
Purchase of common stock for treasury ............................. (604) --
Payment of cash dividend on preferred stock ....................... (50) (50)
Payment of deferred loan costs .................................... (89) (86)
------- -------
Net cash provided by (used in) financing activities ......... 5,222 (857)
------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ..................... 358 (1,841)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ....................... 1,377 3,006
------- -------
CASH AND CASH EQUIVALENTS, END OF PERIOD ............................. $ 1,735 $ 1,165
======= =======
See accompanying notes to condensed consolidated financial statements.
Page 11
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
NOTE 1 -- INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, NEW ACCOUNTING
PRONOUNCEMENTS AND RECLASSIFICATIONS
Interim Condensed Consolidated Financial Statements. The interim condensed
consolidated financial statements of The Hallwood Group Incorporated and
Subsidiaries (the "Company") (AMEX: HWG) have been prepared in accordance with
the instructions to Form 10-Q and do not include all of the information and
disclosures required by accounting principles generally accepted in the United
States of America, although, in the opinion of management, all adjustments
considered necessary for a fair presentation have been included. These condensed
financial statements should be read in conjunction with the audited consolidated
financial statements and related disclosures thereto included in Form 10-K for
the year ended December 31, 2002.
Continuing Operations. The Company is a holding company that classifies its
primary continuing business operations into two segments; real estate and
textile products. During 2002, the Company re-entered the energy business as a
28% owner in a private energy company, Hallwood Energy Corporation ("HEC"),
which is not considered a material business segment.
The Company's real estate activities are conducted primarily through
wholly-owned subsidiaries. One of the subsidiaries serves as the general partner
of Hallwood Realty Partners, L.P. ("HRP"), a publicly traded master limited
partnership. Revenues are generated from the receipt of management fees, leasing
commissions and other fees from HRP and third parties, and the Company's pro
rata share of earnings of HRP using the equity method of accounting.
The textile products operations are conducted through the Company's
wholly-owned Brookwood Companies Incorporated subsidiary ("Brookwood").
Brookwood is an integrated textile service firm that develops and produces
innovative fabrics and related products through specialized finishing, treating
and coating processes. Brookwood's subsidiary, Strategic Technical Alliance, LLC
("STA"), produces advanced breathable, waterproof laminate fabrics primarily for
military applications. Continued development of these fabrics for military,
industrial and consumer applications is a key element of Brookwood's business
plan.
The Company invested $3,500,000 in HEC during 2002 and an additional
$1,992,000 in 2003 (including $941,000 in October 2003). HEC is presently in the
development stage, having drilled 21 wells in the Barnett Shale Formation of
Johnson County, Texas. The Company owns approximately 28% of HEC and accounts
for the investment using the equity method of accounting. Certain of the
Company's officers and directors are investors in HEC. See Note 3.
Discontinued Operations. In December 2000, the Company discontinued its
hotel segment, which at that time consisted of five hotel properties. Two hotels
were disposed of in 2001, one hotel was sold in January 2002 and the lender
completed a foreclosure on one hotel in May 2002. The Company continues to
operate a leasehold interest in one hotel.
New Accounting Pronouncements. Statement of Financial Accounting Standards
No. 148 - Accounting for Stock Based Compensation - Transition and Disclosure,
an Amendment of FASB Statement No. 123 ("SFAS No. 148"), was issued in December
2002. This statement provides new transition methods if an entity adopts the
fair value-based method of valuing stock-based compensation suggested in SFAS
No. 123 - Accounting for Stock Based Compensation, as well as requiring
additional disclosures in interim and annual financial statements. No options
have been granted since 2000. As all options were fully vested as of December
31, 2000, there is no difference between the historical operations and pro forma
operations for the periods presented herein had the expense provisions of SFAS
No. 123 been adopted.
Statement of Financial Accounting Standards No. 149 - Amendment of
Statement 133 on Derivative Instruments and Hedging Activities ("SFAS No. 149"),
was issued in April 2003. SFAS No. 149 amends and clarifies accounting for
derivative instruments, including certain derivative instruments embedded in
other contracts, and for hedging activities under SFAS No. 133. The statement is
generally effective for contracts entered into or modified after June 30, 2003.
The implementation of SFAS No. 149 did not have a material impact on the
Company's financial results.
Statement of Financial Accounting Standards No. 150 - Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity ("SFAS No. 150"), was issued in May 2003. SFAS No. 150 establishes
Page 12
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
standards for how an issuer classifies and measures certain financial
instruments with characteristics of both liabilities and equity. It requires
that an issuer classify a financial instrument that is within the scope of SFAS
No. 150 as a liability (or an asset in some circumstances). Many of those
instruments were previously classified as equity. SFAS No. 150 is generally
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. In accordance with SFAS No. 150 , the Company has
reclassified its redeemable Series B Preferred Stock as a liability at the
balance sheet dates.
Reclassifications. Certain reclassifications have been made to prior year
amounts to conform to the classifications used in the current year.
NOTE 2 -- INVESTMENTS IN HRP (DOLLAR AMOUNTS IN THOUSANDS)
AS OF SEPTEMBER 30, 2003 AMOUNT AT INCOME (LOSS) FOR THE
------------------------ WHICH CARRIED AT NINE MONTHS ENDED
COST OR ---------------------------- SEPTEMBER 30,
NUMBER OF ASCRIBED SEPTEMBER 30, DECEMBER 31, ---------------------
DESCRIPTION OF INVESTMENT UNITS VALUE 2003 2002 2003 2002
------------------------- --------- -------- ------------- ------------ -------- --------
HALLWOOD REALTY PARTNERS, L.P.
-- General partner interest...... -- $ 8,650 $ 838 $ 1,350 $ (6) $ 72
-- Limited partner interest...... 330,432 11,787 15,033 12,175 (226) 1,253
------- -------- -------- -------- --------
Totals....................... $ 20,437 $ 15,871 $ 13,525 $ (232) $ 1,325
======== ======== ======== ======== ========
At September 30, 2003, Hallwood Realty, LLC ("Hallwood Realty") and HWG,
LLC, wholly-owned subsidiaries of the Company, owned a 1% general partner
interest and a 21% limited partner interest in its HRP affiliate, respectively.
The Company accounts for its investment in HRP using the equity method of
accounting. In addition to recording its share of HRP's net income (loss), the
Company also records non-cash adjustments for the elimination of intercompany
profits with a corresponding adjustment to equity income (loss), its pro rata
share of HRP's partner capital transactions with corresponding adjustments to
additional paid-in capital and its pro rata share of HRP's comprehensive income
(loss). The cumulative amount of such non-cash adjustments, from the original
date of investment through September 30, 2003, resulted in a $1,789,000 decrease
in the carrying value of the HRP investment. Prior to January 1, 2002, the
Company recorded amortization of the amount that the Company's share of the
underlying equity in net assets of HRP exceeded its investment on the straight
line basis over 19 years. In accordance with Statement of Financial Accounting
Standards No. 142 - Goodwill and Other Intangibles ("SFAS No. 142"), the
unamortized amount of such "negative goodwill" in the amount of $568,000, as of
January 1, 2002, was recorded as income from cumulative effect of a change in
accounting principle.
The carrying value of the Company's investment in the general partner
interest of HRP includes the value of intangible rights to provide asset
management and property management services. The Company amortizes that portion
of the general partner interest ascribed to the management rights. For the nine
months ended September 30, 2003 and 2002 such amortization was $504,000 in each
period. At September 30, 2003, the remaining unamortized cost was $56,000.
As discussed in Note 12, the Delaware Court of Chancery rendered its
decision after remand regarding certain litigation involving the Company in July
2003. The court determined that the defendants, including the Company, should
pay to HRP a judgment of $2,988,000, plus pre-judgment interest of $3,762,000
from August 1995. The judgment amount, which represented the court's
determination of an underpayment by the Company for certain limited partnership
units purchased by the Company in 1995 from HRP, was in addition to a judgment
amount of $3,417,000 in the Court's original ruling, and was considered
additional purchase price and added to the Company's investment in the limited
partnership units. The interest component of the judgment was recorded as
litigation expense, net of the Company's pro rata share of that amount which is
expected to be recorded as income by HRP. The Company also recorded its pro rata
share of $3,000,000 in attorney's fees payable by HRP to plaintiff's attorneys,
in accordance with the court's final order and judgment, expected to be recorded
as an expense by HRP. The Company made a $5,000,000 payment against this
obligation in August 2003. The remaining balance ($1,796,000 at September 30,
2003) bears simple interest at the statutory rate of 7%.
Page 13
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
The Company has pledged 300,397 HRP limited partner units to collateralize
the former Term Loan and Revolving Credit Facility and the Amended and Restated
Credit Agreement, and the remaining 30,035 units secure all of the capital
leases. See Note 4.
The quoted market price per HRP limited partner unit and the Company's
carrying value per unit (AMEX symbol HRY) at September 30, 2003 were $127.00 and
$45.49, respectively. The general partner interest is not publicly traded.
Tender Offer. On May 1, 2003, High River Limited Partnership ("High
River"), an affiliate of Carl C. Icahn, announced its unsolicited tender offer
for any and all of the outstanding limited partnership units of HRP at $100 per
unit. In May 2003, the board of directors of Hallwood Realty evaluated the offer
and advised HRP unitholders to reject the offer as inadequate. On July 29, 2003,
and in a subsequent letter addressed to the board of directors of Hallwood
Realty, Mr. Icahn announced a purported proposal to purchase HRP in a merger
transaction for an aggregate purchase price of $222 million, subject to existing
debt. On August 1, 2003, at the direction of its board of directors, Hallwood
Realty sent a letter to Mr. Icahn stating that HRP had engaged Morgan Stanley &
Co. Incorporated to initiate discussions with parties interested in
participating in a transaction with HRP and stating that, if Mr. Icahn were
interested in participating in that process, he should contact Morgan Stanley.
On August 19, 2003, High River announced an increase in the purchase price in
its tender offer to $120 per unit, subject to a variety of conditions, including
High River achieving ownership of 66 2/3% of the outstanding HRP units.
Thereafter, the board of directors of Hallwood Realty evaluated the revised
offer and advised unitholders to reject the offer as inadequate. Prior to the
tender offer, High River owned 235,000 units and as of October 17, 2003, 60,986
units had been tendered to High River. The offer has been extended several times
and currently expires November 18, 2003.
At the direction of the board of directors of Hallwood Realty, Morgan
Stanley is actively engaged in a process of identifying alternatives that may be
in the best interests of the HRP unitholders, focusing primarily on discussions
with prospective parties interested in participating in a transaction with HRP
at prices and on terms which the Hallwood Realty board believes would be in the
best interest of all partners of HRP, including an extraordinary transaction,
such as a merger, reorganization or liquidation, involving HRP or any of its
subsidiaries or a purchase, sale or transfer of a material amount of assets by
HRP or any of its subsidiaries. Although HRP is working with Morgan Stanley and
these interested parties, there can be no assurance that a transaction with
respect to HRP will result from those discussions.
NOTE 3-- INVESTMENT IN HEC (DOLLAR AMOUNTS IN THOUSANDS)
AS OF SEPTEMBER 30, 2003 AMOUNT AT INCOME (LOSS) FOR THE
------------------------ WHICH CARRIED AT NINE MONTHS ENDED
COST OR ---------------------------- SEPTEMBER 30,
NUMBER OF ASCRIBED SEPTEMBER 30, DECEMBER 31, ---------------------
DESCRIPTION OF INVESTMENT SHARES VALUE 2003 2002 2003 2002
------------------------- --------- ------- ------------- ------------ -------- --------
HALLWOOD ENERGY CORPORATION
Common stock........... 2,241 $ 4,551 $ 4,563 $ 3,313 $ 199 $ (121)
======= ======= ======= ====== ======
The Company owns approximately 28% of HEC. It accounts for the investment
using the equity method of accounting and records its pro rata share of HEC's
net income (loss), stockholders' equity transactions and comprehensive income
(loss) adjustments, if any.
The Company invested $3,500,000 in HEC during 2002 and an additional
$1,992,000 in 2003 (including $941,000 in October 2003). HEC is presently in the
development stage and has drilled or is drilling 21 wells in the Barnett Shale
formation of Johnson County, Texas. After constructing a gas gathering system,
HEC commenced commercial production and sales of natural gas in February 2003.
Currently, nine wells are producing, two wells have been temporarily abandoned,
three wells are being drilled and six wells are in various stages of completion
and/or connection to the gathering system. Additionally, HEC has drilled and is
completing a Texas Railroad Commission Class 1 disposal well, which should
commence operations prior to the end of 2003 and will serve HEC's disposal needs
as well as accommodate disposed water from third parties.
Page 14
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
Aggregate natural gas production, including royalty owner share and minor
working interest participation, has risen to five million cubic feet per day, as
of November 1, 2003, however, the wells are temporarily producing below their
capabilities due to restrictions at HEC's sales and metering facilities. HEC has
recently increased the delivery capacity at its facilities to accommodate the
additional production.
HEC currently plans to spud or drill an additional 5 to 10 wells during the
balance of 2003 and at present is planning to continue its drilling pace during
2004. The number of wells drilled may vary based upon a variety of operational
and economic conditions and additional capital will be required. HEC currently
anticipates that it will solicit equity contributions from its shareholders in
combination with secured and unsecured borrowings to meet its capital
requirements.
HEC holds oil and gas leases covering approximately 38,000 gross and 34,000
net acres of undeveloped leasehold, predominantly in Johnson County, Texas, as
of November 1, 2003.
Certain of the Company's officers and directors are investors in HEC.
NOTE 4 -- LOANS PAYABLE
Loans payable at the balance sheet dates are as follows (in thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
Textile Products
Revolving credit facility, prime + 0.25% or
Libor + 3.00%, due January 2004 ............................ $10,021 $10,000
Acquisition credit facility, prime + 1.00% or
Libor + 3.25%, due January 2004 ............................ 1,000 1,000
Equipment term loan, 9.37% fixed, due October 2005 ............ 474 623
Equipment term loan, 5.10% fixed, due March 2007 .............. 394 469
Equipment term loan, 5.60% fixed, due September 2008 .......... 330 --
Equipment term loan, 4.67% fixed, due December 2007 ........... 262 298
Equipment term loan, libor + 3.25%, due April 2008 ............ 136 --
------- -------
Sub total ............................................... 12,617 12,390
Subordinated secured promissory note, prime rate, due July 2004 339 596
Subordinated promissory note, non-interest bearing,
due February 2005 .......................................... 156 261
------- -------
13,112 13,247
Other
Loans payable
Revolving credit facility, prime + 0.50% or
Libor + 3.25%, but not less than 4.25%, due May 2005 .... 5,000 --
Revolving credit facility, prime + 0.50% or
Libor + 3.25%, due April 2005 ........................... 2,800 500
Term loan, 7% fixed, due April 2005 ........................ 1,589 2,317
Promissory note, non-interest bearing, due December 2004 ... 195 --
------- -------
Sub total ............................................... 9,584 2,817
Capital lease obligations, 12.18% fixed , due December 2004 ... 649 1,066
------- -------
10,233 3,883
------- -------
Total ................................................... $23,345 $17,130
======= =======
Further information regarding loans payable is provided below:
Page 15
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
TEXTILE PRODUCTS
Revolving Credit Facility. The Company's Brookwood subsidiary has a
revolving credit facility in an amount up to $17,000,000 with Key Bank National
Association (the "Key Credit Agreement"). Availability for direct borrowings and
letter of credit obligations under the Key Credit Agreement are limited to the
lesser of the facility amount or the borrowing base, as defined in the
agreement. Borrowings are collateralized by accounts receivable, inventory
imported under trade letters of credit, certain finished goods inventory,
machinery and equipment and all of the issued and outstanding capital stock of
Brookwood and its subsidiaries. The Key Credit Agreement has a maturity date of
January 2, 2004, bears interest at Brookwood's option of prime plus 0.25% (4.25%
at September 30, 2003) or Libor plus 3.00%, contains various covenants,
including maintenance of certain financial ratios, restrictions on payment of
dividends and repayment of debt or cash transfers to the Company. As of
September 30, 2003, Brookwood had approximately $5,853,000 of borrowing base
availability. The outstanding balance at September 30, 2003 was $10,021,000.
Cash dividends and tax sharing payments to the Company are contingent upon
Brookwood's compliance with the covenants contained in the Key Credit Agreement.
Brookwood was not in compliance with its minimum net income covenant at December
31, 2002. Brookwood obtained a waiver for this violation. The Key Credit
Agreement does not contain a minimum net income covenant for 2003. At September
30, 2003, Brookwood was in compliance with its loan covenants.
Acquisition Credit Facility. The Key Credit Agreement provides for a
$2,000,000 acquisition revolving credit line. This facility bears interest at
Brookwood's option of prime plus 1.00% (5.00% at September 30, 2003) or Libor
plus 3.25%. Brookwood has borrowed $1,000,000 under this facility.
The revolving and acquisition facilities, with a combined balance of
$11,021,000 at September 30, 2003, mature in January 2004. Brookwood intends to
extend or refinance these facilities prior to maturity.
Equipment Credit Facility and Term Loans. The Key Credit Agreement provides
for a $2,000,000 equipment revolving credit line. The facility bears interest at
Libor plus 2.75%. In May 2000, Brookwood borrowed $1,000,000 under this credit
line, which was converted into a term loan, at a fixed rate of 9.37%, with a
maturity date of October 2005. In February and December 2002, Brookwood borrowed
an additional $542,000 and $298,000 under this facility and converted those
amounts into term loans, at fixed rates of 5.10% and 4.67%, with maturities of
March and December 2007, respectively. In April 2003, Brookwood borrowed
$142,000 at libor plus 3.25% and converted that amount into a term loan due
April 2008. In September 2003, Brookwood borrowed an additional $330,000 and
converted that amount into a term loan at a fixed rate of 5.60%, due September
2008. Brookwood has $404,000 availability under this facility. The outstanding
balance at September 30, 2003 was $1,596,000.
The outstanding balance of the combined Key Bank credit facilities at
September 30, 2003 was $12,617,000.
Subordinated Secured Promissory Note. Brookwood was a 50% partner in STA
with an unrelated third party until September 2002. In September 2002, STA
purchased the shares owned by the unrelated third party partner, making STA a
wholly-owned Brookwood subsidiary, and gave the seller a promissory note in the
amount of $596,000. The note bears interest at the prime rate (4.00% at
September 30, 2003), requires a quarterly payment of approximately $85,000 and
is due in July 2004. The outstanding balance at September 30, 2003 was $339,000.
Subordinated Promissory Note. As part of the purchase price related to the
acquisition of an entity in 2000, Brookwood gave the seller a $375,000
subordinated promissory note dated March 2002. The interest free note is being
fully amortized over 36 months and has a maturity date of February 2005. The
outstanding balance at September 30, 2003 was $156,000.
Page 16
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
Other
Term Loan and Revolving Credit Facility. In March 2002, the Company and its
HWG, LLC subsidiary entered into a $7,000,000 credit agreement with First Bank &
Trust , N.A. The facility is comprised of a $3,000,000 term loan and a
$4,000,000 revolving credit facility (the "Term Loan and Revolving Credit
Facility").
The revolving credit facility bears interest at the Company's option of
prime plus 0.50%, or Libor plus 3.25%, and matures April 2005. The interest rate
is 4.50% at September 30, 2003. The Company borrowed $500,000 under this
facility as of December 31, 2002. The Company borrowed an additional $800,000
under the facility in March 2003, $1,000,000 in June 2003, $500,000 in July 2003
and therefore had $1,200,000 of unused borrowing capacity at September 30, 2003.
The Company borrowed the remaining $1,200,000 in October 2003 in connection with
the additional investment in HEC. The outstanding principal balance on the
revolving credit facility at September 30, 2003 was $2,800,000.
The term loan bears interest at a fixed rate of 7.0%, matures April 2005
and is fully amortizing requiring a monthly payment of $92,631. The outstanding
principal balance of the term loan at September 30, 2003 was $1,589,000.
Amended and Restated Credit Agreement. In July 2003, the Company and its
HWG, LLC subsidiary entered into an amended and restated credit agreement with
First Bank and Trust, N.A. (the "Amended and Restated Credit Agreement"). In
addition to incorporating the terms of the Term Loan and Revolving Credit
Facility described above, this facility provides for an additional $3,000,000
term loan and an additional $5,000,000 credit facility. The proceeds of the new
$3,000,000 term loan (the "Special Purpose Term Loan") are restricted and must
be used solely to exercise the option associated with the Separation Agreement
discussed in Note 6. The Special Purpose Term Loan bears interest at a fixed
rate of 6%, matures May 2005 and will require a monthly payment of $48,365. The
Company has not yet drawn the Special Purpose Term Loan, as it has not exercised
the option associated with the Separation Agreement.
The proceeds of the new $5,000,000 credit facility (the "Special Purpose
Credit Facility"), drawn in August 2003, were restricted to pay a substantial
portion of the litigation judgment in August 2003 in the Gotham Partners v.
Hallwood Realty Partners, L.P., et al matter discussed in Note 12. The Special
Purpose Credit Facility bears interest at the Company's option of prime plus
0.50% (4.50% at September 30, 2003), or Libor plus 3.25%, but cannot be less
than 4.25%, and matures May 2005. The Special Purpose Credit Facility does not
require principal payments; however, interest is payable monthly. The
outstanding principal balance of the Special Purpose Credit Facility at
September 30, 2003 was $5,000,000.
The Amended and Restated Credit Agreement requires certain mandatory
repayments upon the occurrence of various events, including new debt offerings
and the disposition of certain of the Company's major investments. The Company's
300,397 HRP Limited Partner Units remain as collateral to secure the various
facilities under the Amended and Restated Credit Agreement.
The Amended and Restated Credit Agreement contains various financial and
non-financial covenants, including the maintenance of financial ratios,
restrictions on new indebtedness and the payment of dividends. The Company was
in compliance with its loan covenants for all interim periods during 2003.
Promissory Note. In connection with the settlement of a lawsuit regarding
the Company's former Embassy Suites hotel in Oklahoma City, Oklahoma, the
Company issued a non-interest bearing promissory note in June 2003, in the
amount of $250,000, payable in equal monthly installments over 18 months. The
outstanding balance at September 30, 2003 was $195,000.
Capital Lease Obligations. During 1999, the Company's Brock Suite Hotels
subsidiaries entered into three separate five-year capital lease agreements for
furniture, fixtures and building improvements at a cost of $2,085,000 for three
GuestHouse Suites Plus properties. The Company has pledged 30,035 HRP limited
partner units as additional collateral to secure the leases. The lease terms
commenced January 2000 and expire in December 2004. The combined monthly lease
payment is $46,570 and the effective interest rate is 12.18%. The outstanding
principal balance at September 30, 2003 was $649,000.
Page 17
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
NOTE 5 -- 10% COLLATERALIZED SUBORDINATED DEBENTURES
The Company has an issue of 10% Collateralized Subordinated Debentures (the
"10% Debentures") outstanding due July 31, 2005. The 10% Debentures are listed
on The New York Stock Exchange. For financial reporting purposes, a pro-rata
portion of an unamortized gain in the original amount of $353,000 was allocated
to the 10% Debentures from a previous debenture issue, and is being amortized
over its term. As a result, the effective interest rate is 8.9%.
The 10% Debentures are secured by a junior lien on the capital stock of
Brookwood. Balance sheet amounts are detailed below (in thousands):
SEPTEMBER 30, DECEMBER 31,
DESCRIPTION 2003 2002
------------------------------------------------- ------------- ------------
10% Debentures (face amount)............................. $ 6,468 $ 6,468
Unamortized gain, net of accumulated amortization........ 115 157
------- -------
Totals................................................ $ 6,583 $ 6,625
======= =======
NOTE 6 -- SEPARATION AGREEMENT
In 1999, the Company entered into a separation agreement (the "Separation
Agreement") with a former officer and director. The Separation Agreement
provided that the former officer and director and related trust exchange their
24% stock ownership in the Company for 20% of the Company's limited partner
interest in HRP, 20% of the Company's common stock interest in the former
Hallwood Energy Corporation ("Former HEC"), all of the Company's interest in its
condominium hotel business and future cash payments contingent on the net cash
flow from the Company's real estate management activities, that being the lesser
of 20% of the net cash flow from its real estate management activities for the
preceding quarter or $125,000. These future cash payments are subject to
termination in certain circumstances. The Separation Agreement obligation of
$3,625,000 and $4,000,000 at September 30, 2003 and December 31, 2002,
respectively, represents the estimated future cash payments to the trust through
the period ending December 2004. The Company has an option to extinguish the
future cash payments at any time prior to December 2004 upon the payment of
$3,000,000.
As discussed in Note 4, the Company entered into an Amended and Restated
Credit Agreement in July 2003, which provides for a Special Purpose Term Loan in
the amount of $3,000,000 to be used to exercise the aforementioned option. The
Company anticipates recording a debt extinguishment gain to the extent that the
carrying amount of the Separation Agreement obligations at the time of exercise
exceeds the $3,000,000 exercise price.
NOTE 7 -- DISCONTINUED OPERATIONS - HOTELS
In December 2000, the Company discontinued its hotel segment, principally
by allowing its non-recourse debtholders to assume ownership of the properties
through foreclosure or by selling or otherwise disposing of its hotel
properties. The Company's former hotel segment consisted of three owned
properties and two leased properties.
As of June 2002, the Company completed the disposition of all four hotel
properties it had previously designated as discontinued operations. The Company
determined that it would retain its leasehold interest in the GuestHouse Suites
hotel in Huntsville, Alabama. The Company continues to operate the hotel,
subject to a lease concession from the owner. Accordingly, this hotel has been
classified as an asset held for use and operating results are reported within
continuing operations.
Page 18
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
A summary of the income (loss) from discontinued hotels operations for the
three months and nine months ended September 30, 2002 is detailed below (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2002 SEPTEMBER 30, 2002
------------------ ------------------
Revenue and Gain from Disposition
Gain from extinguishment of debt.................... $ -- $ 5,789
Sales............................................... -- 282
------- -------
-- 6,071
Expenses
Deferred federal income tax expense................. -- 1,800
Operating expenses.................................. -- 325
Interest expense.................................... 15 183
Litigation and other disposition costs.............. -- 44
------- -------
15 2,352
------- -------
Income (loss) from discontinued hotel operations.... $ (15) $ 3,719
======= =======
In January 2002, with assistance and consent of the mortgage lender, the
Company sold the GuestHouse Suites hotel in Tulsa, Oklahoma for $3,000,000. The
Company received no cash proceeds from the sale; however, concurrently with the
sale, it entered into a loan modification and assumption agreement, which
included a release that discharged the Company from any further loan
obligations. The Company recognized a gain from extinguishment of debt of
$2,552,000, before a deferred tax charge of $875,000, in the 2002 first quarter.
In February 2002, the lender for the GuestHouse Suites hotel in Greenville,
South Carolina obtained a court judgement of foreclosure. In connection with the
foreclosure, the lender waived its right to a deficiency judgement against the
Company and completed the foreclosure in June 2002. The Company recognized a
gain from extinguishment of debt of $3,237,000, before a deferred tax charge of
$925,000, in the 2002 second quarter.
The Company was a defendant in two lawsuits regarding guaranties of certain
obligations of the Embassy Suites and Holiday Inn hotels. In February 2003, the
Company settled both matters. The Company agreed (i) to pay $150,000 in cash and
to issue a non-interest bearing promissory note in the amount of $250,000,
payable in equal monthly installments over 18 months, in exchange for a full
release regarding the Embassy Suites hotel and (ii) to pay $250,000 in cash in
exchange for a full release regarding the Holiday Inn hotel. In December 2002,
the Company recorded an additional loss provision in the amount of $247,000 to
fully accrue for these two litigation matters.
NOTE 8 -- DEFERRED REVENUE - NONCOMPETITION AGREEMENT
In March 2001, the Company agreed to sell its investment in Former HEC,
which represented the Company's former energy operations, to Pure Resources II,
Inc., an indirect wholly-owned subsidiary of Pure Resources, Inc. ("Pure"). The
Company received $18,000,000 for its shares of common stock in May 2001 and
received an additional amount of $7,250,000, pursuant to the terms of a
noncompetition agreement that was paid by Pure upon the completion of the merger
in June 2001.
Under the noncompetition agreement, the Company agreed to refrain from
taking certain actions without the prior written consent of Pure and Former HEC.
These covenants were made by the Company in consideration of the transactions
contemplated by the merger agreement and the payment by Pure to the Company. For
a period of three years after the effective date of the merger agreement, the
Company will not, directly or indirectly, engage in oil and gas activities in
certain geographic areas without the prior consent of Pure. The Company also
agreed to keep Former HEC's confidential and proprietary information strictly
confidential.
The Company began amortizing the deferred revenue from the noncompetition
agreement amount of $7,250,000, over a three-year period commencing June 2001.
The amortization was $605,000 and $1,813,000 in each of the three month and nine
month periods ended September 30, 2003 and 2002, respectively.
Page 19
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
NOTE 9 -- INCOME TAXES
Following is a schedule of the income tax expense (benefit) (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
2003 2002 2003 2002
------- ------- ------- -------
Continuing Operations
Federal
Deferred ............... $(2,374) $ 390 $(5,125) $ 1,476
Current ................ 20 11 74 34
------- ------- ------- -------
Sub-total .............. (2,354) 401 (5,051) 1,510
State expense ............. 300 105 699 350
------- ------- ------- -------
Total .................. $(2,054) $ 506 $(4,352) $ 1,860
======= ======= ======= =======
Discontinued Operations
Federal
Deferred ............... -- $ -- -- $ 1,800
======= ======= ======= =======
The deferred tax asset (net of valuation allowance) was $9,346,000 at
September 30, 2003 and $4,221,000 at December 31, 2002. The deferred tax asset
arises principally from the anticipated utilization of the Company's net
operating loss carryforwards ("NOLs") and tax credits from the implementation of
various tax planning strategies, which include an anticipated gain from the
potential sale of the HRP limited partner units and projected income from
operations. As a result of the appreciation in market value of the HRP limited
partner units during 2003, management determined that the valuation allowance
should be reduced to reflect the anticipated increase in utilization of NOLs.
Accordingly, the Company recorded a deferred tax benefit of $2,374,000 for the
quarter and $5,125,000 for the nine months in 2003.
State tax expense is an estimate based upon taxable income allocated to
those states in which the Company does business, at their respective tax rates.
Page 20
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
NOTE 10 -- SUPPLEMENTAL DISCLOSURES TO THE CONDENSED CONSOLIDATED
STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------
DESCRIPTION 2003 2002
--------------------------------------------------------------------- -------- --------
Supplemental schedule of non-cash investing and financing activities:
Issuance of promissory note in litigation settlement ............. $ 250 --
Hotel assets and liabilities relinquished in connection with debt
extinguishment:
Loan payable ............................................... -- $ 11,609
Other liabilities, net ..................................... -- 837
Hotel properties ........................................... -- (6,552)
Deferred tax asset ......................................... -- (1,800)
-------- --------
-- $ 4,094
======== ========
Pro rata share of partners' capital transactions from equity
investment in HRP:
Amortization of interest rate swap........................... $ (41) $ (44)
Exercise of stock options ..................................... (23) --
Supplemental disclosures of cash payments:
Interest paid .................................................... $ 1,207 $ 1,393
Income taxes paid (refunded) ..................................... 813 (128)
NOTE 11 -- INCOME PER COMMON SHARE
The following table reconciles the Company's net income to net income
available to common stockholders - assuming dilution, and the number of common
shares used in the calculation for the basic and assuming dilution methods (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ ------------------
DESCRIPTION 2003 2002 2003 2002
----------------------------------------------- ------- ------- ------- -------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
Net income .................................... $ 4,820 $ 1,283 $ 7,004 $ 8,043
Less cash dividend on preferred stock ......... -- -- (50) (50)
Interest expense (net of tax) of assumed loan
conversion .................................. -- -- -- 28
------- ------- ------- -------
Net income available to
common stockholders - assuming dilution ..... $ 4,820 $ 1,283 $ 6,954 $ 8,021
======= ======= ======= =======
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic ......................................... 1,340 1,361 1,354 1,361
Potential shares from assumed exercise of
stock options ............................... 204 -- 125 --
Potential repurchase of shares from proceeds of
assumed exercise of stock options ........... (143) -- (93) --
Potential shares from assumed loan conversion . -- -- -- 72
------- ------- ------- -------
Assuming dilution ........................... 1,401 1,361 1,386 1,433
======= ======= ======= =======
Page 21
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
NOTE 12 -- LITIGATION, CONTINGENCIES AND COMMITMENTS
Reference is made to Note 18 to the consolidated financial statements
contained in Form 10-K for the year ended December 31, 2002.
Litigation. In June 1997, an action was filed against the Company, HRP, the
general partner Hallwood Realty Corporation, a predecessor entity to Hallwood
Realty, and the directors of Hallwood Realty Corporation by Gotham Partners,
L.P. in the Court of Chancery of the state of Delaware, styled Gotham Partners,
L.P. v. Hallwood Realty Partners, L.P., et al (C.A. No.15754). As filed, the
action alleged claims of breach of fiduciary duties, breach of HRP's partnership
agreement and fraud in connection with certain transactions involving HRP's
limited partnership units in the mid 1990's. The Company was alleged to have
aided and abetted the alleged breaches. In June 2000, after completing fact
discovery, all parties moved for summary judgment on several issues. In
September and October 2000, the Delaware court issued three separate written
opinions resolving the summary judgment motions. In the opinions, the court
ruled that trial would be required as to all issues, except that (i) Gotham was
found to have standing to pursue its derivative claims; (ii) defendants were
entitled to judgment dismissing the fraud claim; (iii) the general partner was
entitled to judgment dismissing the breach of fiduciary duty claims brought
against it; and (iv) the general partner's outside directors were entitled to
judgment dismissing all claims brought against them. A five-day trial was held
in January 2001.
In July 2001, the Delaware Court of Chancery rendered its opinion. In its
decision, the court determined that an option plan and a sale of HRP units to
the Company in connection with a reverse split of units implemented by HRP in
1995 were in compliance with HRP's partnership agreement. The court also found
that the sale of units to the Company in connection with a 1995 odd-lot offer by
HRP did not comply with certain procedures required by the HRP partnership
agreement. The court ruled that the defendants other than HRP pay a judgment to
HRP in the amount of $3,417,000, plus pre-judgment interest of approximately
$2,891,000 from August 1995. The judgment amount represents what the court
determined was an underpayment by the Company. In August 2001, the plaintiff and
certain defendants appealed the Court of Chancery's judgment to the Delaware
Supreme Court. In October 2001, the Company paid $6,405,000, including
post-judgment interest, to HRP, subject to an arrangement that it be returned in
full or part if the judgment was modified or reversed on appeal. In August 2002,
the Supreme Court affirmed the judgment of the trial court that the remaining
defendants other than HRP are jointly and severally liable to HRP. The Supreme
Court reversed the trial court's determination of damages, and remanded the case
to the trial court to fashion appropriate relief.
In July 2003, the Delaware Court of Chancery issued its decision after
remand. In the decision, the Court of Chancery determined that defendants,
including the Company, were required to pay to HRP the difference between the
price paid for 293,539 units of HRP purchased by the Company in 1995 of $14.20
per unit and the value of those units, including a control premium for those
units, as determined by the court in its decision, of $36.02 per unit, plus
pre-judgment interest. The court also denied plaintiff's requests for
rescission, rescissory damages or other forms of relief. In its earlier decision
before remand, the trial court had determined that the value of the units was
$25.84 per unit and, as mentioned above, the Company paid the judgment amount
plus interest in October 2001. Under the trial court's decision on remand the
Company was required to pay an additional amount of approximately $2,988,000
plus pre-judgment interest of approximately $3,762,000. On July 25, 2003, the
trial court entered its final order and judgment on remand which provided, among
other things, that HRP pay plaintiffs $3,000,000 in attorneys' fees, cost and
expenses. On July 28, 2003, the plaintiff appealed the final order and judgment
on remand to the Delaware Supreme Court.
As discussed in Note 4, the Company entered into an Amended and Restated
Credit Agreement, which provided a Special Purpose Credit Facility in the amount
of $5,000,000, which was used to pay a portion of the litigation judgment in
August 2003. As of September 30, 2003, $1,796,000, including interest, remained
unpaid and is reflected on the Company's balance sheet within "Interest,
litigation and other accrued expenses". The balance bears simple interest at the
statutory rate of 7% until paid.
In April 2003, an action was filed against HRP's general partner, Hallwood
Realty (the "General Partner"), its directors and HRP as nominal defendant by
High River, which is indirectly wholly-owned by Carl C. Icahn, in the Court of
Chancery of the State of Delaware, styled High River Limited Partnership v.
Hallwood Realty, LLC, et al, (C.A. No. 20276). The action, as filed initially,
challenged the unit purchase rights agreement dated November 30, 1990, between
HRP and EquiServe Trust Company, N.A., as rights agent, as amended (the "Rights
Plan"). High River claimed in the suit that defendants have wrongfully utilized
the Rights Plan to prevent High River and other third parties from purchasing
15% or more of the units of HRP, while at the same time exempting the General
Partner and its affiliates and subsidiaries
Page 22
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
from the provisions of the Rights Plan. High River asserts that if defendants
make additional purchases of units, they could render removal of the General
Partner pursuant to the two-thirds removal provision of the partnership
agreement impossible, thereby impeding or preventing the High River tender
offer. High River also claims that defendants wrongfully refused to redeem the
rights and thereby frustrated High River's tender offer. The complaint, as
amended, seeks as relief an order redeeming the rights, preventing defendants
from treating the General Partner as exempt from or otherwise not subject to the
definition of Acquiring Person under the Rights Agreement, or, alternatively,
preventing defendants from treating High River as an Acquiring Person under the
Rights Agreement or applying the Rights Agreement to the High River tender
offer. The parties are proceeding with discovery.
In April 2003, a putative class action lawsuit was filed against the
General Partner, its directors and HRP as nominal defendant by three purported
unitholders of HRP in the Court of Chancery of the State of Delaware, styled
I.G. Holdings, Inc., et al, v. Hallwood Realty LLC, et al, (C.A. No. 20283). The
action asserts that in allegedly refusing to consider the High River tender
offer, the defendants are not acting in good faith and are deriving an improper
personal benefit in impeding a potential removal of the General Partner or a
sale of control of HRP, in breach of their fiduciary duties under the
partnership agreement. The action further asserts that HRP's Schedule 14D-9
issued in response to the High River tender offer fails to disclose material
information relating to the General Partner's recommendation regarding the
offer. The complaint seeks as relief an order requiring the General Partner to
consider the High River tender offer, an order preventing the General Partner or
its affiliates from acquiring units or otherwise improperly entrenching the
General Partner or impeding a transaction that would maximize value for the
public unitholders, an order directing the defendants to use the Rights Plan
fairly and disclose all material information in connection with the tender offer
and the General Partner's recommendations and conclusions with respect thereto,
and damages. This matter was coordinated with the High River action (discussed
above) for discovery and trial purposes.
On October 7-8, 2003, a trial in the two coordinated actions discussed
above was held in the Delaware Court of Chancery. Subsequently, the court
scheduled a status conference for December 3, 2003, at which the court would
determine what further proceedings, if any, were appropriate in the actions.
The Company was a party to certain litigation in the Delaware Court of
Chancery styled, Corporate Property Associates 6 and Corporate Property
Associates 7 v. The Hallwood Group Incorporated (C.A. 15661 - NC), that involved
a four-year, $500,000 promissory note of the Company due March 1998. The note
was secured by a pledge of 89,269 HRP limited partner units. The agreement under
which the note was issued also provided that the pledgee ("CPA," or the
"Noteholder") had the right to receive up to an additional $500,000 based on the
increase in price of the HRP units (the "HRP Participation Amount"). In 1996,
the Company and CPA entered into an agreement under which the Company would pay
off the principal and interest on the note and all other obligations between the
parties would be ended. Subsequently, CPA refused to go forward with the
agreement and this litigation was instituted. In December 1999, the Company and
the Noteholder entered into an agreement, approved by the court, which provided
that (i) the Company pay the face amount of $500,000 plus $83,000 of accrued
interest to the Noteholder; (ii) the Company deposit $900,000 into an escrow
account to secure the maximum amount which could be payable by the Company,
including a potential claim of $400,000 for legal fees; and (iii) that the
noteholder release its collateral of 89,269 HRP units. The parties reserved
their rights to proceed with the litigation. Trial was held in June 2001 in the
Delaware Court of Chancery. In February 2002, the court rendered its decision in
favor of the Company. In March 2002, the court entered an order that provided
for the return of approximately $971,000, including accrued interest, to the
Company from the escrow account. The Noteholder filed an appeal in April 2002.
Oral arguments before the Delaware Supreme Court were heard in September 2002,
and a rehearing en banc was held in November 2002. In March 2003, the Delaware
Supreme Court issued its opinion reversing the finding of the Trial Court that
certain language in the letter agreement in question constituted a general
release of Hallwood's obligations. On March 21, 2003, the parties submitted to
the Chancery Court an agreed proposed Order and Judgment, which was signed by
the Chancery Court and terminated the litigation. The Order and Judgment
provided for payment out of the escrowed funds of approximately $547,000 to CPA
and $437,000 to the Company. The Company received its share of the escrowed
funds on March 31, 2003.
The Company was a defendant in two lawsuits regarding guaranties of
certain obligations of the Embassy Suites and Holiday Inn hotels. In February
2003, the Company settled both matters. The Company agreed (i) to pay $150,000
in cash and to issue a non-interest bearing promissory note in the amount of
$250,000 payable in equal monthly installments over 18 months, in exchange for a
full release regarding the Embassy Suites hotel, and (ii) $250,000 in cash in
exchange for a full release regarding the Holiday Inn hotel. In December 2002,
the Company recorded an additional loss provision in the amount of $247,000 to
fully accrue for these two litigation matters.
Page 23
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
The Company and its subsidiaries are from time to time involved in various
other legal proceedings in the ordinary course of their respective businesses.
Management believes that the resolution of the aforementioned litigation matters
will not have a material adverse effect on the financial condition, results of
operations or cash flows of the Company.
Contingencies. The Company has committed to make additional contributions
to the capital of Hallwood Realty, upon demand, up to a maximum aggregate amount
of $13,118,000, subject to the terms of a subscription agreement, to the extent
Hallwood Realty has insufficient capital to satisfy creditors of HRP. No such
demands have been made.
In December 1999, the Company distributed certain assets and incurred a
contingent obligation under the Separation Agreement. A contingent obligation
exists to the extent that the Company fails to exercise its option to extinguish
future cash payments of up to $500,000 per year, which has no stated maturity.
The Company has an option to extinguish the future cash payments at any time
prior to its expiration in December 2004 upon payment of $3,000,000. See Note 6.
In October 2003, Brookwood received a Notice of Violation from Rhode Island
state authorities regarding certain environmental matters. Brookwood expects the
cost of resolving these matters to be approximately $1,600,000 over the next
three years, which relates primarily to the purchase and installation of various
environmental control equipment.
In February 2000, Brookwood, through a wholly-owned subsidiary, acquired
the assets of a company in a textile products-related industry. The purchase
price was $1,479,000 in cash plus contingent payments of up to $3,000,000, based
on specified levels of earnings over the next four years. Effective December 31,
2001, in consideration of 36 monthly payments aggregating approximately
$375,000, the contingent obligation was reduced to a percentage of cash flow
from the acquired subsidiaries, as defined, for the remaining years under the
agreement. No amounts have been paid or were owed in relation to this
contingency.
NOTE 13 -- SEGMENT AND RELATED INFORMATION
The following represents the Company's reportable segment operations for
the nine months ended September 30, 2003 and 2002, respectively (in thousands):
REAL TEXTILE DISCONTINUED
ESTATE PRODUCTS OTHER OPERATIONS CONSOLIDATED
-------- -------- -------- ------------ ------------
NINE MONTHS ENDED SEPTEMBER 30, 2003
Total revenue from external sources....... $ 3,341 $ 75,239 $ 3,074 $ 81,654
======= ======== ======== ========
Operating income (loss)................... $ (1,649) $ 4,783 $ 3,134
======== ========
Unallocable (loss), net................... $ (482) (482)
======== --------
Income from continuing operations
before income taxes................... $ 2,652
========
NINE MONTHS ENDED SEPTEMBER 30, 2002
Total revenue from external sources....... $ 5,339 $ 62,692 $ 3,298 $ 71,329
======= ======== ======== ========
Operating income.......................... $ 3,835 $ 1,889 $ 5,724
======= ========
Unallocable (loss), net................... $ (108) (108)
======== --------
Income from continuing operations
before income taxes................... $ 5,616
========
Income from discontinued operations....... $ 3,719 $ 3,719
======== ========
No differences have occurred in the basis or methodologies used in the
preparation of this interim segment information from those used in the December
31, 2002 annual report. The total assets for the Company's operating segments
have not materially changed since the December 31, 2002 annual report.
Page 24
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(UNAUDITED)
NOTE 14 -- CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
SFAS No. 142 became effective January 1, 2002 and specifies that goodwill
and some intangible assets will no longer be amortized but instead will be
subject to periodic impairment testing. The effect of adopting SFAS No. 142
resulted in the recording of income from the cumulative effect of a change in
accounting principle in the amount of $568,000, which represented the
unamortized amount of negative goodwill associated with the Company's equity
investment in HRP.
NOTE 15 -- STOCKHOLDERS' EQUITY
In August 2003, the Company purchased 35,000 of its common shares in a
private transaction for approximately $604,000. The cost of the shares was
recorded as treasury stock.
Page 25
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
The Company reported net income of $4,820,000 for the third quarter ended
September 30, 2003, compared to $1,283,000 in 2002. Net income for the nine
month periods was $7,004,000 and $8,043,000, respectively.
Income from continuing operations was $4,820,000 for the third quarter of
2003, compared to $1,298,000 in 2002. Revenue from continuing operations was
$28,517,000 in the third quarter of 2003, compared to $21,088,000 in 2002.
Income from continuing operations for the nine months in 2003 was $7,004,000,
compared to income of $3,756,000 in 2002. Revenue from continuing operations for
the nine months was $81,654,000, compared to $71,329,000 in 2002.
OVERVIEW
Fee income from real estate operations has remained consistent in recent
years, with an occasional spike in lease fees due to the execution of a large
lease or development fee due to completion of a major project. Correspondingly,
during the same period expenses have been fairly steady, except for the
litigation expense in 2001 and 2003. Income from operations, excluding the
litigation expense, was $4,604,000, $5,527,000 and $3,755,000, respectively, for
the three years ended December 31, 2002. Future income and cash flows are
largely dependent on the leasing, development and management activities of the
Company's subsidiaries on behalf of HRP. As discussed in Note 12, the Company
continues to face litigation risk related to its real estate operations. An
adverse ruling could impact the Company's general partner and limited partner
ownership interests in HRP and disrupt the Company's income and cash flow
stream.
Textile products sales continue to experience severe competitive pressures
from low-cost imports. This industry has been in decline in the United States;
however, Brookwood continues to identify new market niches to replace sales lost
to importers. In addition to its existing products and proprietary technologies,
Brookwood has been developing advanced breathable, waterproof laminate
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 enterprise value of Brookwood
is contingent on its ability to adapt to the global textile industry; however,
there can be no assurance that the positive results of the past can be
sustained.
The textile products business is not interdependent with any of the
Company's other business operations. The Company does not guarantee the
Brookwood bank debt and is not obligated to contribute additional capital. If
the textile products business were to deteriorate, creditors could look only to
Brookwood's assets for the satisfaction of its obligations.
The Company invested $3,500,000 in HEC during 2002 and an additional
$1,992,000 in 2003 (including $941,000 in October 2003). HEC is presently in the
development stage and has drilled or is drilling 21 wells in the Barnett Shale
formation of Johnson County, Texas. The Company owns 28% of HEC and accounts for
the investment using the equity method of accounting. Certain of the Company's
officers and directors are investors in HEC.
In December 2000, the Company discontinued its hotel segment, which at that
time consisted of five hotel properties. Two hotels were disposed of in 2001,
one hotel was sold in January 2002 and the lender completed a foreclosure on one
hotel in May 2002. The Company continues to operate a leasehold interest in one
hotel.
Following is an analysis of the results of continuing operations for the
real estate, textile products and other business segments, as well as the
discontinued operations for the hotel business segment.
REAL ESTATE
The real estate segment reported income of $776,000 for the third quarter
of 2003 and a loss of $1,649,000 for the nine month period of 2003, compared to
income of $1,309,000 and $3,835,000 in 2002, respectively.
Revenues. Fee income of $1,175,000 for the 2003 third quarter decreased by
$357,000, or 23%, compared to $1,532,000 in 2002. Fee income of $3,573,000 for
the 2003 nine month period decreased by $441,000, or 11%, compared to $4,014,000
in 2002. Fees are derived from the Company's asset management, property
management, leasing and construction supervision services provided to HRP and
various third parties. The decreases were due primarily to lower leasing fees in
the 2003 periods.
Page 26
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Equity income (loss) from investments in HRP represents the Company's pro
rata share of net income (loss) reported by HRP, adjusted for the elimination of
intercompany profits. For the 2003 third quarter, the Company reported equity
income of $115,000, compared to $378,000 in 2002. For the 2003 nine months, the
equity loss was $232,000, compared to income of $1,325,000 in 2002. The
decreases resulted principally from HRP's litigation costs and other costs
associated with a tender offer for the HRP limited partner units by High River
in 2003.
Expenses. Litigation expense of $45,000 and $3,647,000 in the 2003 third
quarter and nine months periods, respectively, represents the interest component
of the judgment in the Gotham Partners, L.P. v. Hallwood Realty Partners, L.P.
et al matter discussed in Note 12, net of the Company's pro rata share of that
amount, which is expected to be recorded as income by HRP, and the Company's
share of attorneys' fees payable by HRP to plaintiff's attorneys expected to be
recorded as an expense by HRP.
Administrative expenses of $301,000 decreased by $132,000, or 30%, in the
2003 third quarter, compared to $433,000 in 2002. For the nine months, the
decrease was $161,000 to $839,000, from $1,000,000 in 2002. The decreases were
primarily attributable to the payments of commissions associated with leasing
income.
Amortization expense of $168,000 for the third quarter and $504,000 for the
nine months in both the 2003 and 2002 periods related to Hallwood Realty's
general partner investment in HRP to the extent allocated to management rights,
which is being amortized over a ten-year period ending in October 2003. At
September 30, 2003, there was $56,000 of unamortized investment remaining.
TEXTILE PRODUCTS
The textile products segment reported income of $2,202,000 and $4,783,000
for the third quarter and nine month periods of 2003, compared to $606,000 and
$1,889,000 in 2002, respectively.
Revenue. Sales of $26,174,000 increased by $8,391,000, or 47%, in the 2003
third quarter, compared to $17,783,000 in the 2002 third quarter. The
comparative nine month sales increased by $13,704,000, or 22%, to $75,239,000
from $61,535,000 in the 2002 period. The increases were principally due to
additional sales of specialty fabric to U.S. military contractors.
During 2000, Brookwood formed Strategic Technical Alliance ("STA"), a 50-50
joint venture, with an unrelated third party that is also in a textile-related
industry. STA acquired the 50% ownership interest not owned by Brookwood in
September 2002. Accordingly, STA became a wholly-owned subsidiary in September
2002. Prior to the acquisition, Brookwood utilized the equity method of
accounting for its investment in STA. Brookwood's equity income from STA was
$434,000 and $1,157,000 in the 2002 third quarter and nine month periods,
respectively. Since September 2002, the results of STA have been fully
consolidated.
Expenses. Cost of sales of $20,298,000 increased by $5,382,000, or 36%, in
the 2003 third quarter, compared to $14,916,000 in the 2002 third quarter. For
the nine months, the cost of sales increased by $7,261,000, or 14%, to
$59,381,000 in 2003 from $52,120,000 in 2002. The increases were attributable to
the increased sales. The higher gross profit margin for the 2003 third quarter
(22.4% versus 16.1%) and the nine month periods (21.1% versus 15.3%) resulted
from the sales increase of specialty fabric to U.S. military contractors.
Administrative and selling expenses of $3,510,000 increased by $995,000, or
40%, in the 2003 third quarter, compared to $2,515,000 for the 2002 period. For
the nine months, administrative and selling expenses increased $2,450,000, or
30%, to $10,579,000 from $8,129,000 in 2002. The increases were primarily
attributable to royalties incurred in 2003 to the Company's former joint venture
partner in STA and payroll.
Interest expense of $164,000 decreased by $16,000, or 9%, for the 2003
third quarter, compared to $180,000 in 2002. For the nine month periods,
interest expense of $496,000 decreased by $58,000, or 10%, from $554,000 for the
comparable 2002 period. The decreases were principally due to lower interest
rates.
Page 27
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OTHER
The other segment reported a loss of $212,000 for the third quarter of
2003, compared to a loss of $111,000 in 2002. For the nine months, the other
segment reported a loss of $482,000, compared to a loss of $108,000 in 2002.
Revenue. Amortization of deferred revenue of $605,000 and $1,813,000 in
both the 2003 and 2002 third quarter and nine month periods, respectively, is
attributable to the noncompetition fee received in connection with the sale of
the Company's investment in Former HEC. The original $7,250,000 cash payment is
being amortized over a three year period, which began June 2001.
Hotel revenue, which relates entirely to the leased Guest House Suites Plus
hotel in Huntsville, Alabama, was $354,000 in the 2003 third quarter and
$1,058,000 for the nine months, compared to $392,000 and $1,290,000 in the
comparable 2002 periods. The 18% decrease in 2003 was attributable to reduced
occupancy, partially offset by an increased average daily rate. Revenues have
been adversely impacted by a general downturn in the hotel industry and
increased competition in the local market.
Equity income from investment in HEC in the amount of $92,000 for the 2003
third quarter and $199,000 for the nine months relates to the Company's pro rata
share of income from HEC's operations, compared to equity losses of $44,000 and
$121,000, respectively, in the comparable 2002 periods.
Interest and other income decreased to $2,000 for the 2003 third quarter,
compared to $8,000 in 2002. For the nine months, interest and other income was
$4,000 in 2003, compared to $316,000 in 2002. The decrease was principally
attributable to a gain of $296,000 from the exercise of an option and related
sale of a marketable security in the 2002 first quarter.
Expenses. Administrative expenses of $508,000 for the 2003 third quarter
increased by $92,000, or 22%, from $416,000 in 2002, principally due to the
timing in recording of shareholder relations costs. For the nine months,
administrative expenses increased by $67,000, or 5%, to $1,457,000 from
$1,390,000 in 2002. The increase was principally due to increased professional
fees.
Hotel expenses, which include operating expenses, depreciation and interest
costs were $518,000 for the 2003 third quarter, which increased by $69,000, or
15%, compared to $449,000 in 2002. For the nine months, hotel expenses increased
by $58,000 to $1,437,000 from $1,379,000 in 2002. The increases were principally
due to higher maintenance and repair expenses.
Interest expense in the amount of $239,000 for the 2003 third quarter
increased by $32,000 from $207,000 in 2002. For the nine months, interest
expense increased by $25,000 to $662,000 from $637,000 in 2002. The increases
were principally due to borrowings under the former Term Loan and Revolving
Credit Facility and Amended and Restated Credit Agreement, partially offset by
the repayment of the stockholder loan in 2002.
INCOME TAXES
Income taxes relating to continuing operations was a net benefit of
$2,054,000 for the 2003 third quarter, compared to an expense of $506,000 in
2002. The 2003 third quarter included a $2,374,000 non cash federal deferred
benefit, a $20,000 federal current charge and $300,000 for state taxes. The
non-cash federal deferred benefit in 2003 is principally due a reduction in the
valuation allowance related to the deferred tax asset, attributed to the
increased value and potential gain on sale of the HRP limited partner units. The
2002 quarter included a $390,000 non-cash federal deferred charge, a $11,000
federal current charge and $105,000 for state taxes.
Income taxes relating to continuing operations was a net benefit of
$4,352,000 for the 2003 nine month period, compared to an expense of $1,860,000
in 2002. The nine months in 2003 included a deferred tax benefit of $5,125,000,
a $74,000 federal current charge and $699,000 for state taxes. The non-cash
federal deferred benefit in 2003 is principally due a reduction in the valuation
allowance related to the deferred tax asset, attributed to the increased value
and potential gain on sale of the HRP limited partner units. The 2002 nine month
amount included a non-cash deferred tax charge of $1,476,000, a federal current
charge of $34,000 and state tax expense of $350,000. The state tax expense is an
estimate based upon taxable income allocated to those states in which the
Company does business at their respective tax rates.
Page 28
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
As of September 30, 2003, for financial reporting purposes, the Company had
approximately $78,000,000 of tax net operating loss carryforwards ("NOLs") and
temporary differences to reduce future federal income tax liability. Based upon
the Company's expectations and available tax planning strategies, management has
determined that taxable income will more likely than not be sufficient to
utilize approximately $27,500,000 of the NOLs prior to their ultimate expiration
in the year 2020.
Management believes that the Company has certain tax planning strategies
available, which include the potential sale of certain real estate investments,
that could be implemented, if necessary, to supplement income from operations to
fully realize the net recorded tax benefits before their expiration. Management
has considered such strategies in reaching its conclusion that, more likely than
not, taxable income will be sufficient to utilize a portion of the NOLs before
expiration; however, future levels of operating income and taxable gains are
dependent upon general economic conditions and other factors beyond the
Company's control. Accordingly, no assurance can be given that sufficient
taxable income will be generated for utilization of the NOLs. Management
periodically re-evaluates its tax planning strategies based upon changes in
facts and circumstances and, accordingly, considers potential adjustments to the
valuation allowance of the deferred tax asset. Although the use of such NOLs
could, under certain circumstances, be limited, the Company is presently unaware
of the occurrence of any event which would result in such limitations. In
addition, utilization of NOLs in the future may be limited if changes in the
Company's stock ownership create a change in control, as provided in Section 382
of the Internal Revenue Code of 1986, as amended.
DISCONTINUED OPERATIONS - HOTELS
In December 2000, the Company decided to discontinue its hotel operations
and dispose of its hotel segment, principally by allowing its non-recourse
debtholders to assume ownership of the properties through foreclosures or by
selling or otherwise disposing of its hotel properties. The Company's former
hotel segment consisted of three owned properties and two leased properties. In
accordance with accounting standards for reporting discontinued operations,
hotel operations (apart from the leasehold interest in the GuestHouse Suites
Plus hotel in Huntsville, Alabama that the Company continues to operate and has
been classified as an asset held for use) have been segregated from the
Company's continuing operations and have been reported as a single line item --
Loss from Discontinued Operations. Discontinued operations for the three month
and nine month periods ended September 30, 2002 are presented below (in
thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2002 SEPTEMBER 30, 2002
---------------------- ---------------------
Revenue and Gain from Disposition
Gain from extinguishment of debt.................... $ -- $5,789
Sales............................................... -- 282
----- ------
-- 6,071
Expenses
Deferred federal income tax expense................. -- 1,800
Operating expenses.................................. -- 323
Interest expense.................................... -- 183
Litigation and other disposition costs.............. 15 46
---- ------
15 2,352
---- ------
Income (loss) from discontinued hotel operations.... $(15) $3,719
==== ======
As of June 2002, the Company completed the disposition of all four hotel
properties it had previously designated as discontinued operations.
Revenue. In January 2002, with assistance and consent of the mortgage
lender, the Company sold the GuestHouse Suites hotel in Tulsa, Oklahoma for
$3,000,000. The Company received no cash proceeds from the sale; however,
concurrently with the sale, it entered into a loan modification and assumption
agreement which included a release that discharges the Company from any further
loan obligations. The Company recognized a gain from extinguishment of debt of
$2,552,000, before a deferred tax charge of $875,000, in the 2002 first quarter.
Page 29
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
In February 2002, the lender for the GuestHouse Suites hotel in Greenville,
South Carolina obtained a court judgment of foreclosure. In connection with the
foreclosure, the lender waived its right to a deficiency judgment against the
Company and completed the foreclosure in June 2002. The Company recognized a
gain from extinguishment of debt of $3,237,000, before a deferred tax charge of
$925,000 in the 2002 second quarter.
Sales of $282,000 in the 2002 nine month period were principally
attributable to the GuestHouse Suites hotel in Greenville, South Carolina, prior
to its disposition in June 2002.
Expenses. Operating expenses of $323,000 and interest expense of $183,000
for the 2002 nine months related to the Greenville hotel prior to its
disposition. The litigation and other disposition costs principally relate to
legal fees and other expenses in connection with the disposition and resolution
of two litigation matters discussed below.
The Company was a defendant in two lawsuits regarding guaranties of certain
obligations of the Embassy Suites and Holiday Inn hotels. In February 2003, the
Company settled both matters. The Company agreed (i) to pay $150,000 in cash and
to issue a non-interest bearing promissory note in the amount of $250,000
payable in equal monthly installments over eighteen months, in exchange for a
full release regarding the Embassy Suites hotel and (ii) to pay $250,000 in cash
in exchange for a full release regarding the Holiday Inn hotel. In December
2002, the Company recorded an additional loss provision in the amount of
$247,000 to fully accrue for these two litigation matters.
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
SFAS No. 142 became effective January 1, 2002 and specifies that goodwill
and some intangible assets will no longer be amortized but instead will be
subject to periodic impairment testing. The effect of adopting SFAS No. 142 by
the Company resulted in the recording of income from the cumulative effect of a
change in accounting principle in the amount of $568,000, which represented the
unamortized amount of negative goodwill associated with the Company's equity
investment in HRP.
INVESTMENT IN HALLWOOD ENERGY CORPORATION
The Company owns approximately 28% of HEC. It accounts for the investment
using the equity method of accounting and records its pro rata share of HEC's
net income (loss), stockholders' equity transactions and comprehensive income
(loss) adjustments, if any.
The Company invested $3,500,000 in HEC during 2002 and an additional
$1,992,000 in 2003 (including $941,000 in October 2003). HEC is presently in the
development stage and has drilled or is drilling 21 wells in the Barnett Shale
formation of Johnson County, Texas. After constructing a gas gathering system,
HEC commenced commercial production and sales of natural gas in February 2003.
Currently, nine wells are producing, two wells have been temporarily abandoned,
three wells are being drilled and six wells are in various stages of completion
and/or connection to the gathering system. Additionally, HEC has drilled and is
completing a Texas Railroad Commission Class 1 disposal well, which should
commence operations prior to the end of 2003 and will serve HEC's disposal needs
as well as accommodate disposed water from third parties.
Aggregate natural gas production, including royalty owner share and minor
working interest participation, has risen to five million cubic feet per day, as
of November 1, 2003, however, the wells are temporarily producing below their
capabilities due to restrictions at HEC's sales and metering facilities. HEC has
recently increased the delivery capacity at its facilities to accommodate the
additional production.
HEC currently plans to spud or drill an additional 5 to 10 wells during the
balance of 2003 and at present is planning to continue its drilling pace during
2004. The number of wells drilled may vary based upon a variety of operational
and economic conditions and additional capital will be required. HEC currently
anticipates that it will solicit equity contributions from its shareholders in
combination with secured and unsecured borrowings to meet its capital
requirements.
HEC holds oil and gas leases covering approximately 38,000 gross and 34,000
net acres of undeveloped leasehold, predominantly in Johnson County, Texas as of
November 1, 2003.
Page 30
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
There have been no changes to critical accounting policies identified and
set forth in the Company's Annual Report on Form 10-K for the year ended
December 31, 2002.
RELATED PARTY TRANSACTIONS
HRP. The Company's real estate subsidiaries earn asset management, property
management, leasing and construction supervision fees for their management of
HRP's real estate properties. Hallwood Realty earns: (i) an asset management fee
equal to 1% of the net aggregate base rents of HRP's properties; (ii)
acquisition fees equal to 1% of the purchase price of newly acquired properties
and; (iii) disposition fees with respect to real estate investments, other than
the properties owned at the time of HRP's formation in 1990, equal to 10% of the
amount by which the sales price of a property exceeds the purchase price of such
property. HCRE earns property management, leasing and construction supervision
fees. The management contracts with HRP expire on June 30, 2004 and provide for:
(i) a property management fee equal to 2.85% of cash receipts collected from
tenants; (ii) leasing fees equal to the current commission market rate as
applied to net aggregate rent (none exceeding 6% of the net aggregate rent); and
(iii) construction supervision fees for administering construction projects
equal to 5% of total construction or tenant improvement costs.
A summary of the fees earned from HRP is detailed below (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ ------------------
2003 2002 2003 2002
-------- -------- -------- --------
Property management fees .... $ 469 $ 522 $ 1,467 $ 1,516
Leasing fees ................ 373 714 1,063 1,404
Asset management fees ....... 153 155 456 464
Construction supervision fees 142 69 439 454
-------- -------- -------- --------
Total ..................... $ 1,137 $ 1,460 $ 3,425 $ 3,838
======== ======== ======== ========
Hallwood Realty is also reimbursed for certain costs and expenses, at cost,
for administrative level salaries and bonuses, employee and director insurance
and allocated overhead costs. In addition, since HRP does not employ any
individuals, the compensation and other costs related to approximately 90
employees rendering services on behalf of HRP and its properties are reimbursed
to Hallwood Realty and HCRE by HRP.
Page 31
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
HSC Financial Corporation. The Company has entered into a financial
consulting contract with HSC Financial Corporation ("HSC"), a corporation
associated with Mr. Anthony J. Gumbiner, the Company's chairman and principal
stockholder. The contract provides for HSC to furnish and perform international
consulting and advisory services to the Company and its subsidiaries, including
strategic planning and merger activities, at a rate of $795,000 per year. HSC is
also eligible for bonuses from the Company or its subsidiaries, subject to
approval by the Company's or its subsidiaries' board of directors. Additionally,
the Company reimburses HSC for reasonable and necessary expenses of office space
and administrative services. A summary of the fees and expenses paid to HSC are
detailed below (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- -----------------
2003 2002 2003 2002
---- ---- ---- ----
Consulting fees....................................... $198 $198 $596 $596
Office space and administrative services.............. 27 27 77 68
---- ---- ---- ----
Total............................................... $225 $225 $673 $664
==== ==== ==== ====
In addition, HSC performs services for certain affiliated entities that are
not subsidiaries of the Company, for which it receives consulting fees, bonuses
or other forms of compensation and expenses. The Company recognizes a
proportionate share of such compensation and expenses, based upon its ownership
percentage in the affiliated entities, through the utilization of the equity
method of accounting.
HEC. The Company invested $3,500,000 in HEC during 2002 and an additional
$1,992,000 in 2003 (including $941,000 in October 2003). The Company owns
approximately 28% of HEC and accounts for the investment using the equity method
of accounting. Certain of the Company's officers and directors are investors in
HEC.
Brookwood. During 2000, Brookwood formed STA with an unrelated third party
that is also in a textile-related industry, principally to produce advanced,
breathable, waterproof laminate materials for military applications. In
September 2002, STA acquired the 50% ownership interest not owned by Brookwood
for $1,000,000 in cash, the issuance of a $596,000 note bearing interest at the
prime rate and royalty payments for three years based upon production under a
specified contract. Accordingly, STA became a wholly-owned subsidiary of
Brookwood in September 2002. Brookwood reported sales to STA of $2,640,000 and
$11,621,000 for the three month and nine month periods ended September 30, 2002,
respectively.
CONTRACTUAL OBLIGATIONS, COMMERCIAL COMMITMENTS AND FINANCIAL COVENANTS
The Company and its subsidiaries have entered into various contractual
obligations and commercial commitments in the ordinary course of conducting its
business operations, which are provided below as of September 30, 2003 (in
thousands):
PAYMENTS DUE DURING THE YEAR ENDING DECEMBER 31,
------------------------------------------------------------------
2003* 2004 2005 2006 2007 THEREAFTER TOTAL
------ ------- ------- ---- ---- ---------- -------
CONTRACTUAL OBLIGATIONS
Long term debt
Amended and Restated
Credit Agreement................. $ 252 $ 1,052 $ 8,085 $ -- $ -- $ -- $ 9,389
Loan Payable ..................... 42 153 -- -- -- -- 195
10% Debentures (face amount)....... -- -- 6,468 -- -- -- 6,468
Loans payable (Brookwood).......... 221 11,870 478 277 196 70 13,112
Capital lease obligations............ 105 544 -- -- -- -- 649
Separation Agreement................. 125 3,500 -- -- -- -- 3,625
Operating leases..................... 281 1,076 834 653 538 1,614 4,996
------ ------- ------- ---- ---- ------ -------
Total............................ $1,026 $18,195 $15,865 $930 $734 $1,684 $38,434
====== ======= ======= ==== ==== ====== =======
Page 32
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
DURING THE YEAR ENDING DECEMBER 31,
---------------------------------------------------------------
2003* 2004 2005 2006 2007 THEREAFTER TOTAL
---- ---- ---- ---- ---- ---------- -----
COMMERCIAL COMMITMENTS
Employment contracts................. $ 50 $200 $50 -- -- -- $300
Letters of credit.................... 126 - -- -- -- -- 126
---- ---- --- --- --- --- ----
Total.............................. $176 $200 $50 -- -- -- $426
==== ==== === === === === ====
---------------
* For the three months ending December 31, 2003.
FINANCIAL COVENANTS
The Company's Amended and Restated Credit Agreement and 10% Debentures
require compliance with various loan covenants and financial ratios, which, if
not met, will trigger a default. The Amended and Restated Credit Agreement
requires a minimum debt service coverage ratio, as defined, for each rolling
four quarter period, a senior leverage ratio, as defined, and a minimum
collateral value coverage. Additionally, Brookwood's Key Credit Agreement
requires compliance with various loan covenants and financial ratios,
principally a debt service coverage ratio and a debt to equity ratio.
Amended and Restated Credit Agreement. The principal ratios, as defined in
the Amended and Restated Credit Agreement and the former Term Loan and Revolving
Credit Facility, as of the end of the interim quarters in the year ending
December 31, 2003 and for the quarter ended December 31, 2002 are provided below
(dollar amount in thousands):
QUARTERS ENDED
-------------------------------------------------------
SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31,
DESCRIPTION REQUIREMENT 2003 2003 2003 2002
------------------------- ------------------------------ ------------ ------- -------- -----------
Net cash flow, as defined must exceed $4,400 (a)........ $8,331 $6,967 $5,995 $5,941
Debt service coverage must exceed 1.2 to 1.0........ 2.22 1.96 1.77 2.01
Senior leverage must be less than 2.5 to 1.0.. 1.58 1.81 1.45 1.53
Collateral value coverage must exceed 200% of loan
balance..................... 406% 733% 769% 877%
----------------
(a) Requirement was $3,400 prior to July 2003
The Company was in compliance with its loan covenants under the Amended and
Restated Credit Agreement and the former Term Loan and Revolving Credit Facility
for all interim periods in 2003 and believes that it will be in compliance with
its covenants for the quarter ending December 31, 2003.
10% Debentures. The Indenture for the 10% Debentures contains various
covenants, which if violated, may result in a call of the entire issue. The
principal covenants prohibit any subsidiary of the Company from commencing
receivership, bankruptcy or insolvency proceedings. The Company was in
compliance with the covenants for all interim periods in 2003 and believes it
will be in compliance with its covenants for the quarter ending December 31,
2003.
Page 33
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Key Credit Agreement. The principal ratios, as defined in the Key Credit
Agreement, as of the end of the interim quarters in the year ending December 31,
2003 and for the quarter ended December 31, 2002 are provided below (dollar
amounts in thousands):
QUARTERS ENDED
-------------------------------------------------------
SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31,
DESCRIPTION REQUIREMENT 2003 2003 2003 2002
------------------------- ------------------------------ ------------ ------- -------- -----------
Minimum net income,
as defined must exceed $1,500 ytd 12/31/02 -- -- -- $1,436
Debt service coverage must exceed 1.25 to 1.00...... 2.29 2.06 2.22 1.91
Debt to equity must be less than 45% in 2003;
50% in 2002................... 38% 43% 40% 39%
Brookwood was in compliance with its loan covenants for all interim periods
during 2002, except for the quarter ended December 31, 2002, when it did not
meet its minimum net income loan covenant. The covenant, which required a
minimum net income of $1,500,000, was not met as Brookwood's net income for the
year ended December 31, 2002 was $1,436,000. Brookwood obtained a waiver for
this violation. The Key Credit Agreement does not contain a minimum net income
covenant for 2003. Brookwood was in compliance with its covenants for all
interim periods in 2003, and believes that it will be in compliance with its
covenants for the quarter ending December 31, 2003.
Page 34
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash position increased by $358,000 during the 2003 nine
month period to $1,735,000 as of September 30, 2003. The primary sources of cash
were $242,000 from operating activities and $5,222,000 provided by financing
activities. The primary uses of cash were additional investments of $2,988,000
and $1,051,000 in HRP and HEC, respectively, and $1,067,000 for textile products
equipment.
The Company principally operates in the real estate and textile products
business segments. During 2002, the Company reentered the energy business as a
minority owner in HEC.
The Company's real estate segment generates funds principally from its
property management and leasing activities, without significant additional
capital costs. The Company has pledged 300,397 of its HRP limited partnership
units and the interest in its real estate subsidiaries to collateralize the
Amended and Restated Credit Agreement and the remaining 30,035 HRP units to
secure all of the capital leases.
The Company's textile products segment generates funds from the dyeing,
printing and laminating of fabrics and their sale to customers in the consumer,
industrial, medical and military markets. Brookwood maintains a revolving line
of credit facility and separate acquisition and equipment facilities. At
September 30, 2003, Brookwood had approximately $5,853,000 of unused borrowing
capacity on its revolving line of credit facility. In the year ended December
31, 2002 and nine month period ended September 30, 2003, Brookwood paid $250,000
and $1,062,000, respectively, to the Company under its tax sharing agreements,
but paid no cash dividends. Future cash dividends and tax sharing payments to
the Company are contingent upon Brookwood's compliance with the covenants
contained in the credit facility. Brookwood was in compliance with its loan
covenants for all interim periods in 2002, except for the quarter ended December
31, 2002, when it did not meet its minimum net income loan covenant. The
covenant, which required a minimum net income of $1,500,000, was not met as
Brookwood's net income was $1,436,000. Brookwood obtained a waiver for this
violation. The loan does not contain a minimum net income covenant for 2003.
Brookwood was in compliance with its covenants for all interim periods in 2003,
and believes that it will be in compliance with its covenants for the quarter
ending December 31, 2003.
The Brookwood revolving and acquisition facilities, with a combined balance
of $11,021,000 at September 30, 2003, mature in January 2004. Brookwood intends
to extend or refinance these facilities prior to maturity.
In March 2002, the Company and its HWG, LLC subsidiary entered into a
$7,000,000 credit agreement with First Bank & Trust, N.A. The Term Loan and
Revolving Credit Facility was comprised of a $3,000,000 term loan and a
$4,000,000 revolving credit facility. The term loan proceeds were used in part
to repay the $1,500,000 convertible loan from a stockholder in March 2002. The
term loan bears interest at a fixed rate of 7%, matures April 1, 2005 and is
fully amortizing requiring a monthly payment of $92,631. The revolving credit
facility bears interest at the Company's option of prime plus 0.50%, or Libor
plus 3.25%, and matures April 1, 2005. Collateral for the Term Loan and
Revolving Credit Facility is 300,397 HRP limited partner units. The credit
agreement contains various financial and non-financial covenants, including the
maintenance of financial ratios, restrictions on new indebtedness and the
payment of dividends. The Company borrowed $500,000 under the Revolving Credit
Facility in 2002 and $3,500,000 in 2003 (including $1,200,000 in October 2003),
and therefore has no unused borrowing capacity.
In July 2003, the Company and HWG, LLC entered into the Amended and
Restated Credit Agreement with First Bank and Trust, N.A. In addition to
incorporating the terms of the Term Loan and Revolving Credit Facility, this
facility provides for an additional $3,000,000 term loan and an additional
$5,000,000 credit facility. The proceeds of the new $3,000,000 Special Purpose
Term Loan are restricted and must be used solely to exercise the option
associated with the Separation Agreement discussed in Note 6 to the condensed
consolidated financial statements. The Special Purpose Term Loan bears interest
at a fixed rate of 6%, matures May 2005 and will require a monthly payment of
$48,365. The Company has not yet drawn the Special Purpose Term Loan, as it has
not exercised the option associated with the Separation Agreement.
Proceeds of the new $5,000,000 Special Purpose Credit Facility, drawn in
August 2003, were restricted to pay a substantial portion of the litigation
judgment in the Gotham Partners v. Hallwood Realty Partners, L.P., et al matter
discussed in Note 12 to the condensed consolidated financial statements. The
Special Purpose Credit Facility bears
Page 35
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
interest at the Company's option of prime plus 0.50%, or Libor plus 3.25%, but
cannot be less than 4.25%, and matures May 2005. The Special Purpose Credit
Facility does not require principal payments; however, interest is payable
monthly.
The Amended and Restated Credit Agreement requires certain mandatory
repayments upon the occurrence of various events, including new debt offerings
and the disposition of certain of the Company's major investments.
The Company was in compliance with the loan covenants for the Amended and
Restated Credit Agreement and former Term Loan and Revolving Credit Facility for
all interim periods during 2003.
In July 2001, the Delaware Court of Chancery rendered its opinion regarding
certain litigation involving the Company. The court determined that the
defendants, including the Company, should pay to HRP a judgment of $3,417,000
plus pre-judgment interest of approximately $2,988,000. The court's judgment was
not final until all rehearings and appeals have been exhausted. In August 2001,
the plaintiff and certain defendants appealed the Court of Chancery's judgment
to the Delaware Supreme Court. In October 2001, with a portion of the proceeds
from the sale of its Former HEC investment, the Company paid HRP $6,405,000,
including post-judgment interest, subject to an arrangement that it be returned
in full or part if the judgment is modified or reversed on appeal. As further
discussed in Note 12 to the condensed consolidated financial statements, the
Supreme Court reversed the trial court's determination of damages, and remanded
the case to the trial court to fashion appropriate relief. In July 2003, the
Delaware Court of Chancery issued its decision after remand. In the decision,
the Court of Chancery determined that defendants, including the Company, were
required to pay to HRP the difference between the price paid for 293,539 units
of HRP purchased by the Company in 1995 of $14.20 per unit and the value of
those units, including a control premium for those units, as determined by the
court in its decision, of $36.02 per unit, plus pre-judgment interest. The court
also denied plaintiff's requests for rescission, rescissory damages or other
forms of relief. In its earlier decision before remand, the trial court had
determined that the value of the units was $25.84 per unit and, the Company paid
the judgment amount plus interest in October 2001. Under the trial court's
decision on remand, the Company was required to pay an additional amount of
approximately $2,988,000 plus pre-judgment interest of approximately $3,762,000.
On July 25, 2003, the trial court entered its final order and judgment on remand
which provided, among other things, that HRP pay plaintiffs $3,000,000 in
attorneys' fees, cost and expenses. On July 28, 2003, the plaintiff appealed the
final order and judgment on remand to the Delaware Supreme Court. In August
2003, the Company paid $5,000,000 of the judgment with proceeds from the Special
Purpose Credit Facility and the balance due, $1,796,000 at September 30, 2003,
bears simple interest at the statutory rate of 7%.
In accordance with the Separation Agreement, the Company has an obligation
to pay a trust affiliated with a former officer and director 20% of the net cash
flow from the Company's real estate activities, up to $500,000 per year. These
future cash payments are subject to termination in certain circumstances. The
Company has an option to extinguish the future cash payments at any time prior
to its expiration in December 2004 upon the payment of $3,000,000. The Amended
and Restated Credit Agreement provides for a Special Purpose Term Loan to be
used to exercise the option.
In October 2003, Brookwood received a Notice of Violation from Rhode Island
state authorities regarding certain environmental matters. Brookwood expects the
cost of resolving these matters to be approximately $1,600,000 over the next
three years, which relates primarily to the purchase and installation of various
environmental control equipment.
In February 2000, Brookwood acquired the assets of a company in a textile
products-related industry. The purchase price was $1,479,000 in cash plus
contingent payments of up to $3,000,000, based on specified levels of earnings
over the next four years. Effective December 31, 2001, in consideration of
thirty-six monthly payments aggregating approximately $375,000, the contingent
obligation was reduced to a percentage of cash flow from the acquired
subsidiaries, as defined, for the remaining years under the agreement. No
amounts have been paid or were owed in relation to this contingency.
The Company's ability to generate cash flow from operations sufficient to
make scheduled payments on its debts as they become due will depend on its
future performance and its ability to successfully implement business and growth
strategies. The Company's performance will also be affected by prevailing
economic conditions and the resolution of pending legal matters. Many of these
factors are beyond the Company's control. If future cash flows and capital
resources are insufficient to meet the Company's debt obligations and
commitments, it may be forced to reduce or delay activities and capital
expenditures, obtain additional equity capital beyond what is required under its
current credit facilities or restructure or refinance its debt. In the event
that the Company is unable to do so, it may be left without sufficient
Page 36
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
liquidity and it may not be able to meet its debt service requirements. The
Company believes it can generate sufficient revenues and/or borrow on its credit
facilities to meet its liquidity needs. See Notes 4 and 5 to the Company's
condensed consolidated financial statements.
FORWARD-LOOKING STATEMENTS
In the interest of providing stockholders and debentureholders with certain
information regarding the Company's future plans and operations, certain
statements set forth in this Form 10-Q relate to management's future plans,
objectives and expectations. Such statements are forward-looking statements.
Although any forward-looking statement expressed by or on behalf of the Company
is, to the knowledge and in the judgment of the officers and directors, expected
to prove true and come to pass, management is not able to predict the future
with absolute certainty. Forward-looking statements involve known and unknown
risks and uncertainties, which may cause the Company's actual performance and
financial results in future periods to differ materially from any projection,
estimate or forecasted result. Among others, these risks and uncertainties
include, the ability to obtain financing or refinance maturing debt; a potential
oversupply of commercial office buildings and industrial parks in the markets
served; fees for leasing, construction and acquisition of real estate
properties; lease and rental rates and occupancy levels obtained; the ability to
compete successfully with foreign textile production and the ability to generate
new products; the volatility of natural gas prices; the ability to replace and
expand natural gas reserves; and the imprecise process of estimating natural gas
reserves and future cash flows. These risks and uncertainties are difficult or
impossible to predict accurately and many are beyond the control of the Company.
Other risks and uncertainties may be described, from time to time, in the
Company's periodic reports and filings with the Securities and Exchange
Commission.
Page 37
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes to the Company's market risks during
the quarter ended September 30, 2003.
The Company is exposed to market risk due to fluctuations in interest
rates. The Company utilizes both fixed rate and variable rate debt to finance
its operations. As of September 30, 2003, the Company's total outstanding loans
and debentures payable of $29,813,000 were comprised of $10,517,000 of fixed
rate debt and $19,296,000 of variable rate debt. There is inherent rollover risk
for borrowings as they mature and are renewed at current market rates. The
extent of this risk is not quantifiable or predictable because of the
variability of future interest rates and the Company's future financing
requirements. A hypothetical increase in interest rates of one percentage point
would cause an annual loss in income and cash flows of approximately $298,000,
assuming that outstanding debt remained at current levels.
The Company's real estate division through its investment in HRP will
sometimes use derivative financial instruments to achieve a desired mix of fixed
versus floating rate debt. As of September 30, 2003, HRP had an interest cap
agreement for one of its mortgage loans, which will limit HRP's exposure to
changing interest rates to a maximum of 10%. Management does not consider the
portion attributable to the Company to be significant.
ITEM 4. CONTROLS AND PROCEDURES AND INTERNAL CONTROLS
Controls and procedures. It is the conclusion of the Company's principal
executive officer and principal financial officer that the Company's disclosure
controls (as defined in Exchange Act rules 13a-15(e) and 15d-15(e)), based on
their evaluation of these controls and procedures as of the end of the period
covered by this Quarterly Report, are effective in timely alerting them to the
material information relating to the Company required to be included in its
periodic filings with the Securities and Exchange Commission. Management
necessarily applied its judgment in assessing the costs and benefits of such
controls and procedures which, by their nature, can provide only reasonable
assurance regarding management's control objectives. The design of any system of
controls and procedures is based in part upon certain assumptions about the
likelihood of future events. There can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions,
regardless of how remote.
The Company's independent auditors have provided written communication to
management and the audit committee on the need to improve the closing process at
the Brookwood subsidiary. Management has begun making improvements to this
process.
Internal controls. Other than the improvements noted above, there were no
significant changes in the Company's internal controls or in other factors that
could significantly affect these controls subsequent to the date of their
evaluation.
Page 38
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item
----
1 Legal Proceedings
Reference is made to Note 12 to the Company's condensed consolidated
financial statements included within this Form 10-Q.
2 Changes in Securities None
3 Defaults upon Senior Securities None
4 Submission of Matters to a Vote of Security Holders None
5 Other Information
On May 1, 2003, High River Limited Partnership ("High River"), an
affiliate of Carl C. Icahn, announced its unsolicited tender offer for
any and all of the outstanding limited partnership units of HRP at $100
per unit. In May 2003, the board of directors of Hallwood Realty
evaluated the offer and advised HRP unitholders to reject the offer as
inadequate. On July 29, 2003, and in a subsequent letter addressed to
the board of directors of Hallwood Realty, Mr. Icahn announced a
purported proposal to purchase HRP in a merger transaction for an
aggregate purchase price of $222 million, subject to existing debt. On
August 1, 2003, at the direction of its board of directors, Hallwood
Realty sent a letter to Mr. Icahn stating that HRP had engaged Morgan
Stanley & Co. Incorporated to initiate discussions with parties
interested in participating in a transaction with HRP and stating that,
if Mr. Icahn were interested in participating in that process, he
should contact Morgan Stanley. On August 19, 2003, High River announced
an increase in the purchase price in its tender offer to $120 per unit,
subject to a variety of conditions, including High River achieving
ownership of 66 2/3% of the outstanding HRP units. Thereafter, the
board of directors of Hallwood Realty evaluated the revised offer and
advised unitholders to reject the offer as inadequate. Prior to the
tender offer, High River owned 235,000 units and as of October 17,
2003, 60,986 units had been tendered to High River. The offer has been
extended several times and currently expires November 18, 2003.
At the direction of the board of directors of Hallwood Realty,
Morgan Stanley is actively engaged in a process of identifying
alternatives that may be in the best interests of the HRP unitholders,
focusing primarily on discussions with prospective parties interested
in participating in a transaction with HRP at prices and on terms which
the Hallwood Realty board believes would be in the best interest of all
partners of HRP, including an extraordinary transaction, such as a
merger, reorganization or liquidation, involving HRP or any of its
subsidiaries or a purchase, sale or transfer of a material amount of
assets by HRP or any of its subsidiaries. Although HRP is working with
Morgan Stanley and these interested parties, there can be no assurance
that a transaction with respect to HRP will result from those
discussions.
Page 39
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
6 Exhibits and Reports on Form 8-K
(a) Exhibits
31.1 Certification of the Chief Executive Officer Pursuant to
Section 302 of Sarbanes-Oxley Act of 2002, filed herewith.
31.2 Certification of the Chief Financial Officer Pursuant to
Section 302 of Sarbanes-Oxley Act of 2002, filed herewith.
32.1 Certification of the Chief Executive Officer and Chief
Financial Officer Pursuant to Section 906 of Sarbanes-Oxley
Act of 2002, filed herewith.
(b) Reports on Form 8-K
Dated August 15, 2003 - On August 12, 2003 The Hallwood
Group Incorporated issued a press release regarding its
results of operations for the second quarter ended June 30,
2003. (Such press release is not incorporated by reference
herein or deemed "filed" within the meaning of Section 18
of the Securities Act of 1933, as amended).
--------------------
Page 40
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
THE HALLWOOD GROUP INCORPORATED
Dated: November 13, 2003 By: /s/ Melvin J. Melle
--------------------------------------------
Melvin J. Melle, Vice President
(Principal Financial and Accounting Officer)
Page 41
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
------- ---------------------------------------------------------
31.1 Certification of the Chief Executive Officer, pursuant to
Section 302 of Sarbanes-Oxley Act of 2002
31.2 Certification of the Chief Financial Officer, pursuant to
Section 302 of Sarbanes-Oxley Act of 2002
32.1 Certification of the Chief Executive Officer and Chief
Financial Officer, pursuant to Section 906 of
Sarbanes-Oxley Act of 2002
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