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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 JUNE 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 August 8, 2003.
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THE HALLWOOD GROUP INCORPORATED
TABLE OF CONTENTS
ITEM NO. PART I - FINANCIAL INFORMATION PAGE
-------- ------------------------------ ----
1 Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets as of June 30, 2003
and December 31, 2002................................................... 3
Condensed Consolidated Statements of Income for the
Six Months Ended June 30, 2003 and 2002................................. 5
Condensed Consolidated Statements of Income for the
Three Months Ended June 30, 2003 and 2002............................... 7
Condensed Consolidated Statements of Comprehensive Income for the
Six Months Ended June 30, 2003 and 2002 and
Three Months Ended June 30, 2003 and 2002............................... 9
Condensed Consolidated Statements of Changes in Stockholders'
Equity for the Six Months Ended June 30, 2003 .......................... 10
Condensed Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2003 and 2002................................. 11
Notes to Condensed Consolidated Financial Statements......................... 12
2 Managements's Discussion and Analysis of
Financial Condition and Results of Operations................................ 26
3 Quantitative and Qualitative Disclosures about Market Risk...................... 37
4 Controls and Procedures and Internal Controls................................... 37
PART II - OTHER INFORMATION
1 to 6 Other Information, Exhibits and Reports on Form 8-K............................. 38
Signature Page.................................................................. 40
Index to Exhibits............................................................... 41
Page 2
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
ASSETS
JUNE 30, DECEMBER 31,
2003 2002
------------ ------------
REAL ESTATE
Investments in HRP ................. $ 15,938 $ 13,525
Receivables and other assets
Related parties ................. 422 732
Other ........................... 36 60
------------ ------------
16,396 14,317
TEXTILE PRODUCTS
Inventories ........................ 20,611 18,913
Receivables ........................ 18,718 15,743
Property, plant and equipment, net . 9,027 9,315
Prepaids, deposits and other assets 442 548
------------ ------------
48,798 44,519
OTHER
Deferred tax asset, net ............ 6,972 4,221
Investment in HEC .................. 4,333 3,313
Cash and cash equivalents .......... 3,486 1,377
Prepaids, deposits and other assets
Other ........................... 337 317
Related parties ................. 66 140
Hotel assets held for use .......... 307 362
Restricted cash .................... -- 982
------------ ------------
....................................... 15,501 10,712
TOTAL ........................... $ 80,695 $ 69,548
============ ============
See accompanying notes to condensed consolidated financial statements.
Page 3
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
JUNE 30, DECEMBER 31,
2003 2002
------------ ------------
REAL ESTATE
Accounts payable and accrued expenses ............................. $ 196 $ 1,306
TEXTILE PRODUCTS
Loans payable ..................................................... 15,436 13,247
Accounts payable and accrued expenses ............................. 12,883 10,803
------------ ------------
28,319 24,050
OTHER
Interest, litigation and other accrued expenses ................... 7,233 1,274
10% Collateralized Subordinated Debentures ........................ 6,598 6,625
Loans payable ..................................................... 4,372 2,817
Separation Agreement obligations .................................. 3,750 4,000
Deferred revenue - noncompetition agreement ....................... 2,215 3,424
Redeemable preferred stock, Series B .............................. 1,000 1,000
Hotel accounts payable and accrued expenses ....................... 984 850
Capital lease obligations ......................................... 808 1,066
------------ ------------
26,960 21,056
TOTAL LIABILITIES .............................................. 55,475 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 1,361,343 shares at both dates ..................... 240 240
Additional paid-in capital ........................................ 54,429 54,452
Accumulated deficit ............................................... (14,283) (16,417)
Accumulated other comprehensive income ............................ 164 191
Treasury stock, 1,034,760 shares at both dates; at cost ........... (15,330) (15,330)
------------ ------------
TOTAL STOCKHOLDERS' EQUITY ..................................... 25,220 23,136
------------ ------------
TOTAL .......................................................... $ 80,695 $ 69,548
============ ============
See accompanying notes to condensed consolidated financial statements.
Page 4
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
--------------------
2003 2002
-------- --------
REAL ESTATE
Fees
Related parties ............................................. $ 2,288 $ 2,378
Other ....................................................... 110 104
Equity income (loss) from investments in HRP ................... (347) 947
-------- --------
2,051 3,429
Litigation expense ............................................. 3,602 --
Administrative expenses ........................................ 538 567
Amortization ................................................... 336 336
-------- --------
4,476 903
-------- --------
Income (loss) from real estate operations ................... (2,425) 2,526
TEXTILE PRODUCTS
Sales
Trade ....................................................... 49,065 34,771
Related party ............................................... -- 8,981
Equity income from joint venture ............................... -- 723
-------- --------
49,065 44,475
Cost of sales .................................................. 39,083 37,204
Administrative and selling expenses ............................ 7,069 5,614
Interest ....................................................... 332 374
-------- --------
46,484 43,192
-------- --------
Income from textile products operations ..................... 2,581 1,283
OTHER
Amortization of deferred revenue - noncompetition agreement .... 1,208 1,208
Hotel revenue .................................................. 704 898
Equity income (loss) from investment in HEC .................... 107 (77)
Interest and other income ...................................... 2 308
-------- --------
2,021 2,337
Administrative expenses ........................................ 949 974
Hotel expenses ................................................. 919 930
Interest expense ............................................... 423 430
-------- --------
2,291 2,334
-------- --------
Other income (loss) ......................................... (270) 3
-------- --------
Income (loss) from continuing operations before income taxes (114) 3,812
Income tax benefit (expense) ................................ 2,298 (1,354)
-------- --------
Income from continuing operations ........................... 2,184 2,458
See accompanying notes to condensed consolidated financial statements.
Page 5
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
--------------------
2003 2002
-------- --------
Income from discontinued hotel operations, net of tax $ -- $ 3,734
-------- --------
Income before cumulative effect of change in accounting principle 2,184 6,192
Income from cumulative effect of change in accounting principle .... -- 568
-------- --------
NET INCOME ............................................................. 2,184 6,760
Preferred stock dividend ........................................... (50) (50)
-------- --------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS ............................ $ 2,134 $ 6,710
======== ========
PER COMMON SHARE
BASIC
Income from continuing operations after preferred dividend ....... $ 1.57 $ 1.77
Income from discontinued operations .............................. -- 2.74
Income from cumulative effect of change in accounting principle .. -- 0.42
-------- --------
Net income available to common stockholders .................... $ 1.57 $ 4.93
======== ========
ASSUMING DILUTION
Income from continuing operations after preferred dividend ....... $ 1.56 $ 1.66
Income from discontinued operations .............................. -- 2.54
Income from cumulative effect of change in accounting principle .. -- 0.38
-------- --------
Net income available to common stockholders .................... $ 1.56 $ 4.58
======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic .............................................................. 1,361 1,361
======== ========
Assuming dilution .................................................. 1,372 1,470
======== ========
See accompanying notes to condensed consolidated financial statements.
Page 6
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30,
--------------------
2003 2002
-------- --------
REAL ESTATE
Fees
Related parties ............................................. $ 1,081 $ 1,266
Other ....................................................... 70 97
Equity income (loss) from investments in HRP ................... (663) 414
-------- --------
488 1,777
Litigation expense ............................................. 3,602 --
Administrative expenses ........................................ 282 347
Amortization ................................................... 168 168
-------- --------
4,052 515
-------- --------
Income (loss) from real estate operations ................... (3,564) 1,262
TEXTILE PRODUCTS
Sales
Trade ....................................................... 24,266 18,415
Related party ............................................... -- 4,516
Equity income from joint venture ............................... -- 149
-------- --------
24,266 23,080
Cost of sales .................................................. 18,873 19,151
Administrative and selling expenses ............................ 3,517 2,945
Interest ....................................................... 183 208
-------- --------
22,573 22,304
-------- --------
Income from textile products operations ..................... 1,693 776
OTHER
Amortization of deferred revenue - noncompetition agreement .... 604 604
Hotel revenue .................................................. 367 458
Equity income (loss) from investment in HEC .................... 56 (36)
Interest and other income ...................................... 1 4
-------- --------
1,028 1,030
Administrative expenses ........................................ 521 592
Hotel expenses ................................................. 471 493
Interest expense ............................................... 220 225
-------- --------
1,212 1,310
-------- --------
Other income (loss) ......................................... (184) (280)
-------- --------
Income (loss) from continuing operations before income taxes (2,055) 1,758
Income tax benefit (expense) ................................ 2,886 (616)
-------- --------
Income from continuing operations ........................... 831 1,142
See accompanying notes to condensed consolidated financial statements.
Page 7
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30,
--------------------
2003 2002
-------- --------
Income from discontinued hotel operations, net of tax ....... $ -- $ 2,258
-------- --------
NET INCOME ...................................................... 831 3,400
Preferred stock dividend .................................... (50) (50)
-------- --------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS ..................... $ 781 $ 3,350
======== ========
PER COMMON SHARE
BASIC
Income from continuing operations after preferred dividend $ 0.57 $ 0.80
Income from discontinued operations ....................... -- 1.66
-------- --------
Net income available to common stockholders ............. $ 0.57 $ 2.46
======== ========
ASSUMING DILUTION
Income from continuing operations after preferred dividend $ 0.56 $ 0.80
Income from discontinued operations ....................... -- 1.66
-------- --------
Net income available to common stockholders ............. $ 0.56 $ 2.46
======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic ....................................................... 1,361 1,361
======== ========
Assuming dilution ........................................... 1,399 1,361
======== ========
See accompanying notes to condensed consolidated financial statements.
Page 8
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- --------------------
2003 2002 2003 2002
-------- -------- -------- --------
NET INCOME .................................................. $ 831 $ 3,400 $ 2,184 $ 6,760
Other Comprehensive Income (Loss)
Pro rata share of other comprehensive income (loss) from
equity investments
Amortization of interest rate swap ................... (14) (15) (27) (29)
-------- -------- -------- --------
COMPREHENSIVE INCOME ........................................ $ 817 $ 3,385 $ 2,157 $ 6,731
======== ======== ======== ========
See accompanying notes to condensed consolidated financial statements.
Page 9
THE HALLWOOD GROUP INCORPORATED
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 ..................... 2,184 2,184
Pro rata share of partners'
capital transactions from equity
investment: ....................
Exercise of stock options .... (23) (23)
Amortization of interest rate
swap ......................... (27) (27)
Cash dividend on preferred stock (50) (50)
------ --------- ---------- ----------- ------------- ------ -------- -------------
BALANCE, JUNE 30, 2003 ............. 2,396 $ 240 $ 54,429 $ (14,283) $ 164 1,035 $(15,330) $ 25,220
====== ========= ========== =========== ============= ====== ======== =============
See accompanying notes to condensed consolidated financial statements.
Page 10
THE HALLWOOD GROUP INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
-------------------
2003 2002
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income ........................................................ $ 2,184 $ 6,760
Adjustments to reconcile net income to net cash provided by
operating activities:
Accrued litigation expense ..................................... 3,602 --
Deferred tax expense (benefit) ................................. (2,751) 1,086
Amortization of deferred revenue - noncompetition agreement .... (1,208) (1,208)
Depreciation and amortization .................................. 1,139 1,026
Decrease in restricted cash .................................... 982 --
Equity income/loss from investments in HRP ..................... 347 (947)
Equity income/loss from investment in HEC ...................... (107) 77
Amortization of deferred gain from debenture exchange .......... (27) (25)
Equity income from textile products joint venture .............. -- (723)
Income from cumulative effect of changes in accounting principle -- (568)
Net change in textile products assets and liabilities .......... (2,487) 503
Net change in other assets and liabilities ..................... (979) (470)
Discontinued operations:
Net change in other hotel assets and liabilities ............ (400) 242
Gain from extinguishment of hotel debt ...................... -- (5,789)
Deferred tax expense ........................................ -- 1,800
-------- --------
Net cash provided by operating activities ................... 295 1,764
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in HEC common stock .................................... (912) (1,500)
Investments in textile products property and equipment ............ (460) (369)
Investment in hotel held for use .................................. -- (17)
-------- --------
Net cash (used in) investing activities ..................... (1,372) (1,886)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from bank borrowings and loans payable ................... 4,251 3,429
Repayment of bank borrowings and loans payable .................... (1,015) (3,714)
Payment of cash dividend on preferred stock ....................... (50) (50)
Payment of deferred loan costs .................................... -- (86)
-------- --------
Net cash provided by (used in) financing activities ........ 3,186 (421)
-------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ...................... 2,109 (543)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ........................ 1,377 3,006
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD .............................. $ 3,486 $ 2,463
======== ========
See accompanying notes to condensed consolidated financial statements.
Page 11
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 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 (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"), but
HEC 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 through the Company's pro rata share of
earnings of HRP using the equity method of accounting and the receipt of
management fees, leasing commissions and other fees from HRP and third parties.
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 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
$1,051,000 in 2003 (including $139,000 in July 2003). HEC is presently in the
development stage, having drilled and completed nine test 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 Company is evaluating the impact of this statement and does not believe that
is will have a material impact on its financial results.
Page 12
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
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
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 JUNE 30, 2003 AMOUNT AT INCOME (LOSS) FOR THE
------------------- WHICH CARRIED AT SIX MONTHS ENDED
COST OR ---------------------- JUNE 30,
NUMBER OF ASCRIBED JUNE 30, DECEMBER 31, -----------------------
DESCRIPTION OF INVESTMENT UNITS VALUE 2003 2002 2003 2002
------------------------- --------- -------- -------- ------------ ---------- ----------
HALLWOOD REALTY PARTNERS, L.P.
- General partner interest ..... -- $ 8,650 $ 998 $ 1,350 $ (14) $ 43
- Limited partner interest ..... 330,432 11,787 14,940 12,175 (333) 904
-------- -------- ------------ ---------- ----------
Totals ...................... $ 20,437 $ 15,938 $ 13,525 $ (347) $ 947
======== ======== ============ ========== ==========
At June 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 June 30, 2003, resulted in a $1,965,000 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 nineteen 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 six
months ended June 30, 2003 and 2002 such amortization was $336,000 in each
period. At June 30, 2003, the remaining unamortized cost was $224,000.
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 prejudgment 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, is in addition to a judgment
amount of $3,417,000 in the Court's original ruling, was considered additional
purchase price and was 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 it 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 anticipates making a $5,000,000 payment
against this obligation in August 2003. The remaining balance would bear
interest at the statutory rate of 7%.
Page 13
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
The Company has pledged 300,397 HRP limited partner units to collateralize
the Term Loan and Revolving Credit Facility and the Amended and Restated Credit
Agreement and the remaining 30,035 units to 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 June 30, 2003 were $101.00 and
$45.21, respectively. The general partner interest is not publicly traded.
Tender Offer. On May 1, 2003, High River Limited Partnership, 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, HRP
management, the board of directors of Hallwood Realty, and certain professional
advisors evaluated the offer and advised 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
has engaged Morgan Stanley & Co. Incorporated to initiate discussions with
parties interested in participating in a transaction with HRP and stating that
if Mr. Icahn is interested in participating in that process, he should contact
Morgan Stanley. The unsolicited tender offer has subsequently been extended to
September 5, 2003.
The board of directors of Hallwood Realty has authorized its advisors to
continue its evaluation of potential alternatives to the tender offer,
including, without limitation, to initiate 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. Such transaction may include, without limitation, 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 of any of its subsidiaries. There can be no assurance, however,
that HRP will be able to generate interest in any such transaction.
NOTE 3 -- INVESTMENT IN HEC (DOLLAR AMOUNTS IN THOUSANDS)
AS OF JUNE 30, 2003 AMOUNT AT INCOME (LOSS) FOR THE
------------------- WHICH CARRIED AT SIX MONTHS ENDED
COST OR ---------------------- JUNE 30,
NUMBER OF ASCRIBED JUNE 30, DECEMBER 31, -----------------------
DESCRIPTION OF INVESTMENT SHARES VALUE 2003 2002 2003 2002
------------------------- --------- -------- -------- ------------ ---------- ----------
HALLWOOD ENERGY CORPORATION
Common stock........... 2,206 $ 4,412 $ 4,333 $ 3,313 $ 107 $ (77)
======== ======== ============ ========== ==========
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
$1,051,000 in 2003 (including $139,000 in July 2003 when the Company purchased
35 additional shares from an existing shareholder). HEC is presently in the
development stage, having drilled and completed nine test wells in the Barnett
Shale formation of Johnson County, Texas. After constructing a gas gathering
system, HEC commenced commercial production and sales from three of the nine
wells in February 2003. Currently, eight wells are producing and one well has
been temporarily abandoned. Aggregate production, including royalty owner share
and minor working interest participation, rose to 3.0 million cubic feet of gas
per day during the first week of May 2003, and was approximately 2.6 million
cubic feet of gas per day at August 8, 2003. The reduction in production is due
in part to the natural decline experienced in Barnett Shale wells, coupled with
a temporary slow down in drilling activity between May and July 2003.
In addition to the above, HEC has drilled the Worthington #1, which will
serve as a Texas Railroad Commission Class 1 disposal well and will be used to
accommodate disposed water for HEC as well as third parties. Additional
Page 14
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
operations in progress at July 31, 2003 include the drilling of two additional
Barnett Shale wells. HEC anticipates completion operations to commence on these
properties by the middle of August 2003.
HEC currently plans to drill between 10 and 20 wells during the balance of
2003; however, this number may vary based upon a variety of operational and
economic conditions. Whether HEC drills 10 or 20 additional wells this year,
additional capital will be required. HEC currently anticipates that it will
solicit equity contributions from its shareholders in combination with secured
borrowings to meet its capital requirements. Depending on the level of
borrowings, coupled with the ultimate level of well development activity, HEC
may request from its shareholders additional equity contributions over the next
six to eight months of approximately $5,000,000. Based on the Company's current
ownership percentage, if approved by the Company's board of directors, its
equity contribution may total approximately $1,400,000.
HEC holds oil and gas leases covering approximately 34,500 gross and
30,300 net acres of undeveloped leasehold, predominantly in Johnson County,
Texas, as of July 31, 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):
JUNE 30, DECEMBER 31,
2003 2002
------------ ------------
Textile Products
Revolving credit facility, prime + 0.25% or
Libor + 3.00%, due January 2004 ............................ $ 12,451 $ 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 ............ 525 623
Equipment term loan, 5.10% fixed, due March 2007 .............. 419 469
Equipment term loan, 4.67% fixed, due December 2007 ........... 276 298
Equipment term loan, libor + 3.25%, due April 2008 ............ 142 --
------------ ------------
Sub total .............................................. 14,813 12,390
Subordinated secured promissory note, prime rate, due July 2004 425 596
Subordinated promissory note, non-interest bearing,
due February 2005 .......................................... 198 261
------------ ------------
15,436 13,247
Other
Loans payable
Revolving credit facility, prime + 0.50% or
Libor + 3.25%, due April 2005 ............................ 2,300 500
Term loan, 7% fixed, due April 2005 ........................ 1,836 2,317
Promissory note, non-interest bearing, due December 2004 ... 236 --
------------ ------------
Sub total .............................................. 4,372 2,817
Capital lease obligations, 12.18% fixed , due December 2004 ... 808 1,066
------------ ------------
5,180 3,883
------------ ------------
Total .................................................. $ 20,616 $ 17,130
============ ============
Further information regarding loans payable is provided below:
Page 15
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 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 + 0.25% (4.50% at
June 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. The outstanding balance
at June 30, 2003 was $12,451,000.
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 from the lender and
believes it will be in compliance with all of its covenants for 2003. The Key
Credit Agreement does not contain a minimum net income covenant for 2003. At
June 30, 2003, Brookwood was in compliance with its loan covenants.
As of June 30, 2003, Brookwood had approximately $3,090,000 of borrowing
base availability.
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% (5.25% at June 30, 2003) or Libor plus
3.25%. Brookwood has borrowed $1,000,000 under this facility.
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 + 3.25% due April 2008. Brookwood has $638,000
availability under this facility. The outstanding balance at June 30, 2003 was
$1,362,000.
The outstanding balance of the combined Key Bank credit facilities at June
30, 2003 was $14,813,000.
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 (4.25% at June 30,
2003), requires a quarterly payment of approximately $85,000 and is due in July
2004. The outstanding balance at June 30, 2003 was $425,000.
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 June 30, 2003 was $198,000.
The Brookwood revolving and acquisition facilities, with a combined
balance of $13,451,000 at June 30, 2003, mature in January 2004. The Company
intends to extend or refinance these facilities prior to their maturity.
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
Page 16
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
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 4.75% at June 30, 2003. The Company borrowed an additional $800,000 under the
facility in March 2003 and $1,000,000 in June 2003 and therefore had $1,700,000
of unused borrowing capacity at June 30, 2003. The Company borrowed an
additional $500,000 in July 2003 in connection with the acquisition of treasury
stock. The outstanding principal balance on the revolving credit facility at
June 30, 2003 was $2,300,000.
Term loan proceeds were used in part to repay a $1,500,000 convertible
loan from a stockholder. The term loan bears interest at a fixed rate of 7%,
matures April 2005 and is fully amortizing requiring a monthly payment of
$92,631. The outstanding principal balance of the term loan at June 30, 2003 was
$1,836,000.
Amended and Restated Credit Agreement. On July 28, 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").
The 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
("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 requires a monthly payment of $48,365. The proceeds of the new $5,000,000
credit facility ("Special Purpose Credit Facility") are restricted and must be
used solely to pay a portion of the litigation judgment 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%, 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.
Proceeds of the two new facilities must be drawn down prior to August 26,
2003. 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.
Collateral for the Term Loan and Revolving Credit Facility and the Amended
and Restated Credit Agreement is 300,397 HRP limited partner units. The credit
agreements contain 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
under the Term Loan and Revolving Credit Facility and Amended and Restated
Credit Agreement 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 June 30, 2003 was $236,000.
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 June 30, 2003 was $808,000.
NOTE 5 -- 10% COLLATERALIZED SUBORDINATED DEBENTURES
The Company has an issue of 10% Collateralized Subordinated Debentures
("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%.
Page 17
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
The 10% Debentures are secured by a junior lien on the capital stock of
Brookwood. Balance sheet amounts are detailed below (in thousands):
JUNE 30, DECEMBER 31,
DESCRIPTION 2003 2002
-------------------------------------------- ------------ ------------
10% Debentures (face amount) .................... $ 6,468 $ 6,468
Unamortized gain, net of accumulated amortization 130 157
------------ ------------
Totals .................................... $ 6,598 $ 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 a 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 $3,750,000 and
$4,000,000 at June 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
JUNE 30, 2003
(UNAUDITED)
A summary of the income from discontinued hotels operations for the three
months and six months ended June 30, 2002 is detailed below (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2002
------------------ ----------------
Revenue and Gain from Disposition
Gain from extinguishment of debt ........ $ 3,237 $ 5,789
Sales ................................... 67 282
------------------ ----------------
3,304 6,071
Expenses
Deferred federal income tax expense ..... 925 1,800
Operating expenses ...................... 66 323
Interest expense ........................ 46 183
Litigation and other disposition costs .. 9 31
------------------ ----------------
1,046 2,337
------------------ ----------------
Income from discontinued hotel operations $ 2,258 $ 3,734
================== ================
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 $604,000 and $1,208,000 in each of the three month and six
month periods ended June 30, 2003 and 2002, respectively.
Page 19
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
NOTE 9 -- INCOME TAXES
Following is a schedule of the income tax expense (benefit) (in
thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ --------------------
2003 2002 2003 2002
---------- ---------- -------- --------
Continuing Operations
Federal expense (benefit)
Deferred .............. $ (3,147) $ 520 $ (2,751) $ 1,086
Current ............... 25 11 54 23
---------- ---------- -------- --------
Sub-total ........... (3,122) 531 (2,697) 1,109
State expense ........... 236 85 399 245
---------- ---------- -------- --------
Total ............... $ (2,886) $ 616 $ (2,298) $ 1,354
========== ========== ======== ========
Discontinued Operations
Federal expense
Deferred .............. -- $ 925 -- $ 1,800
========== ========== ======== ========
The deferred tax asset (net of valuation allowance) was $6,972,000 at June
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 as
of June 30, 2003, management determined that the valuation allowance related to
the deferred tax asset should be reduced to reflect the anticipated increase in
utilization of NOLs. Accordingly, the Company recorded a deferred tax benefit of
$3,147,000 in the 2003 second quarter.
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
JUNE 30, 2003
(UNAUDITED)
NOTE 10 -- SUPPLEMENTAL DISCLOSURES TO THE CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS
SIX MONTHS ENDED
JUNE 30,
--------------------
DESCRIPTION 2003 2002
------------------------------------------- -------- --------
Supplemental schedule of non-cash investing and financing activities:
Additional investment in HRP pursuant to litigation settlement .. $ 2,988 --
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 ........................... $ (27) $ (29)
Exercise of stock options .................................... (23) --
Supplemental disclosures of cash payments:
Interest paid ................................................... $ 784 $ 988
Income taxes paid (refunded) .................................... 711 (184)
Page 21
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
NOTE 11 -- COMPUTATION OF INCOME PER SHARE
The following table reconciles the Company's income from continuing
operations to income from continuing operations 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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- --------------------
DESCRIPTION 2003 2002 2003 2002
------------------------------------------------ -------- -------- -------- --------
INCOME AVAILABLE TO COMMON STOCKHOLDERS
Income from continuing operations .............. $ 831 $ 1,142 $ 2,184 $ 2,458
Less cash dividend on preferred stock .......... (50) (50) (50) (50)
Interest expense (net of tax) of assumed loan
conversion ................................... -- -- -- 28
-------- -------- -------- --------
Income from continuing operations available to
common stockholders - assuming dilution ...... $ 781 $ 1,092 $ 2,134 $ 2,436
======== ======== ======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic .......................................... 1,361 1,361 1,361 1,361
Potential shares from assumed exercise of
stock options ................................ 125 -- 54 --
Potential repurchase of shares from stock option
proceeds ..................................... (87) -- (43) --
Potential shares from assumed loan conversion .. -- -- -- 109
-------- -------- -------- --------
Assuming dilution .............................. 1,399 1,361 1,372 1,470
======== ======== ======== ========
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 Delaware Court of Chancery, styled Gotham Partners, L.P.
v. Hallwood Realty Partners, L.P., et al (C.A. No.15754). 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 units to the Company in
connection with a reverse unit split 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. Oral arguments before the
Delaware Supreme Court were heard in February 2002, and a rehearing en banc was
held in March
Page 22
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
2002. 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 Hallwood 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 is 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. The $6,750,000
judgment amount plus interest due is to bear interest at the statutory rate of
7% until paid.
As discussed in Note 4, the Company entered into an Amended and Restated
Credit Agreement in July 2003, which provides a Special Purpose Credit Facility
in the amount of $5,000,000. Proceeds of the facility are to be used to pay a
portion of the litigation judgment.
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 Limited Partnership ("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 challenges 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 claims 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 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. 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. Trial is scheduled for
September 2, 2003.
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 has been coordinated with the High River case and is
therefore also scheduled for trial on September 2, 2003.
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 involves
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
Page 23
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
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 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.
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. The contingent
obligation, in the amount of $4,000,000 at December 31, 2002, was the estimated
value of the remaining payments under the Separation Agreement. In December 2001
the Company evaluated the contingent obligation and accrued an additional
$500,000 under this agreement, which was paid in 2002. Similarly, the Company
reevaluated the obligation at December 2002, and determined that a further cost
of $1,000,000 should be accrued, which is expected to be paid in 2003 and 2004.
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.
Further additional capital investments in HEC may be required. Depending
upon the timing of the investments, an additional borrowing under the Company's
revolving credit facility may be required.
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. As of June 30, 2003, no amounts have been paid or were owed in
relation to the contingency payments.
Page 24
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
(UNAUDITED)
NOTE 13 -- SEGMENT AND RELATED INFORMATION
The following represents the Company's reportable segment operations for
the six months ended June 30, 2003 and 2002, respectively (in thousands):
REAL TEXTILE DISCONTINUED CONSOL
ESTATE PRODUCTS OTHER OPERATIONS -IDATED
-------- --------- -------- ------------ --------
SIX MONTHS ENDED JUNE 30, 2003
Total revenue from external sources $ 2,051 $ 49,065 $ 2,021 $ 53,137
======== ========= ======== ========
Operating income (loss) ........... $ (2,425) $ 2,581 $ 156
======== =========
Unallocable (loss), net ........... $ (270) (270)
======== --------
Loss from continuing operations
before income taxes ........... $ (114)
========
SIX MONTHS ENDED JUNE 30, 2002
Total revenue from external sources $ 3,429 $ 44,475 $ 2,337 $ 50,241
======== ========= ======== ========
Operating income .................. $ 2,526 $ 1,283 $ 3,809
======== =========
Unallocable income, net ........... $ 3 3
======== --------
Income from continuing operations
before income taxes ........... $ 3,812
========
Income from discontinued operations $ 3,734 $ 3,734
============ ========
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.
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 -- SUBSEQUENT EVENT
In August 2003, the Company completed the purchase of 35,000 of its common
shares in a private transaction for approximately $604,000. The shares will be
recorded as treasury stock in the third quarter.
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 $831,000 for the second quarter ended
June 30, 2003, compared to $3,400,000 in 2002. Net income for the six month
periods was $2,184,000 and $6,760,000, respectively.
Income from continuing operations was $831,000 for the second quarter of
2003, compared to $1,142,000 in 2002. Revenue from continuing operations was
$25,782,000 in the second quarter of 2003, compared to $25,887,000 in 2002.
Income and revenue from continuing operations for the six months in 2003 were
$2,184,000 and $53,137,000, compared to income and revenue of $2,458,000 and
$50,241,000 in 2002, respectively.
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. Cash flow from operations, excluding the
litigation expense, was $3.8 million, $4.5 million and $4.7 million,
respectively, for the three years ended December 31, 2002. Future 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 and disrupt the Company's cash flow stream.
Textile products sales continues 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
$1,051,000 (including $139,000 in July 2003) in July 2003. HEC is presently in
the development stage, having drilled and completed nine test 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 losses of $3,564,000 for the second
quarter of 2003 and $2,425,000 for the six month period of 2003, compared to
income of $1,262,000 and $2,526,000 in 2002, respectively.
Revenues. Fee income of $1,151,000 for the 2003 second quarter decreased
by $212,000, or 16%, compared to $1,363,000 in 2002. Fee income of $2,398,000
for the 2003 six month period decreased by $84,000, or 3%, compared to
$2,482,000 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
and construction supervision 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 second quarter, the Company reported an
equity loss of $663,000, compared to income of $414,000 in 2002. For the 2003
six months, the equity loss was $347,000, compared to income of $947,000 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 $3,602,000 in the 2003 second quarter
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 $282,000 decreased by $65,000, or 19%, in the
2003 second quarter, compared to $347,000 in 2002. For the six months, the
decrease was $29,000 to $538,000, from $567,000 in 2002. The decreases were
primarily attributable to the payments of commissions associated with leasing
income.
Amortization expense of $168,000 for the second quarter and $336,000 for
the six 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 June
30, 2003, there was $224,000 of unamortized investment remaining.
TEXTILE PRODUCTS
The textile products segment reported income of $1,693,000 and $2,581,000
for the second quarter and six month periods of 2003, compared to $776,000 and
$1,283,000 in 2002, respectively.
Revenue. Sales of $24,266,000 increased $1,335,000, or 6%, in the 2003
second quarter, compared to $22,931,000 in the 2002 second quarter. The
comparative six months sales increased by $5,313,000, or 12%, to $49,065,000
from $43,752,000 in the 2002 period. The increase was 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 $149,000 and $723,000 in the 2002 second quarter and six month periods,
respectively.
Expenses. Cost of sales of $18,873,000 decreased by $278,000, or 1%, in
the 2003 second quarter, compared to $19,151,000 in the 2002 second quarter. The
decrease in cost of sales was principally the result of the sale of higher
margin products. For the six months, the cost of sales increased by $1,879,000,
or 5%, to $39,083,000 in 2003 from $37,204,000 in 2002. The increase was
attributable to the increased sales. The higher gross profit margin for the 2003
second quarter (22.2% versus 16.5%) and the six month periods (20.3% versus
15.0%) resulted from the sales increase of specialty fabric to military
contractors.
Administrative and selling expenses of $3,517,000 increased by $572,000 in
the 2003 second quarter, compared to $2,945,000 for the 2002 period. For the six
months, administrative and selling expenses increased $1,455,000, or 26%, to
$7,069,000 from $5,614,000 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 $183,000 decreased by $25,000, or 12%, for the 2003
second quarter, compared to $208,000 in 2002. For the six months, interest
expense of $332,000 decreased by $42,000, or 11%, from $374,00 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 $184,000 for the second quarter of
2003, compared to a loss of $280,000 in 2002. For the six months, the other
segment reported a loss of $270,000, compared to income of $3,000 in 2002.
Revenue. Amortization of deferred revenue was $604,000 and $1,208,000 in
both the 2003 and 2002 second quarter and six month periods, respectively, and
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 $367,000 in the 2003 second quarter and
$704,000 for the six months, compared to $458,000 and $898,000 in the comparable
2002 periods. The 22% 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 $56,000 for the 2003
second quarter and $107,000 for the six months relates to the Company's pro rata
share of income from HEC's operations, compared to equity losses of $36,000 and
$77,000, respectively, in the comparable 2002 periods.
Interest and other income decreased to $1,000 for the 2003 second quarter,
compared to $4,000 in 2002. For the six months, interest and other income was
$2,000 in 2003, compared to $308,000 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 $521,000 for the 2003 second quarter
decreased by $71,000, or 12%, from $592,000 in 2002. For the six months,
administrative expenses decreased by $25,000 to $949,000 from $974,000 in 2002.
The decreases are primarily due to reduced professional fees.
Interest expense in the amount of $220,000 for the 2003 second quarter
decreased by $5,000 from $225,000 in 2002. For the six months, interest expense
decreased by $7,000 to $423,000 from $430,000 in 2002. The decreases were
primarily due to the repayment of the stockholder loan in 2002, partially offset
by borrowings under the Term Loan and Revolving Credit Facility.
Hotel expenses, which include operating expenses, depreciation and
interest costs were $471,000 for the 2003 second quarter, which decreased by
$22,000, or 4%, compared to $493,000 in 2002. For the six months, hotel expenses
decreased by $11,000 to $919,000 from $930,000 in 2002. The decreases were
principally due to lower repairs and maintenance.
INCOME TAXES
Income taxes relating to continuing operations was a net benefit of
$2,886,000 for the 2003 second quarter, compared to an expense of $616,000 in
2002. The 2003 quarter included a $3,147,000 non cash federal deferred benefit,
a $25,000 federal current charge and $236,000 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
of the HRP limited partner units and the increase in anticipated gain from the
potential sale of the units. The 2002 quarter included a $520,000 non cash
federal deferred charge, a $11,000 federal current charge and $85,000 for state
taxes. Income taxes was a net benefit of $2,298,000 for the 2003 six month
period, compared to an expense of $1,354,000 in 2002. The six months in 2003
included a deferred tax benefit of $2,751,000, a $54,000 federal current charge
and $399,000 for state taxes. The 2002 six month amount included a non-cash
deferred tax charge of $1,086,000, a federal current charge of $23,000 and state
tax expense of $245,000. 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.
As of June 30, 2003, 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
Page 28
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
available tax planning strategies, management has determined that taxable income
will more likely than not be sufficient to utilize approximately $20,500,000 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
carryforwards 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 six month periods ended June 30, 2002 are presented below (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2002
------------------ ----------------
Revenue and Gain from Disposition
Gain from extinguishment of debt ........ $ 3,237 $ 5,789
Sales ................................... 67 282
------------------ ----------------
3,304 6,071
Expenses
Deferred federal income tax expense ..... 925 1,800
Operating expenses ...................... 66 323
Interest expense ........................ 46 183
Litigation and other disposition costs .. 9 31
------------------ ----------------
1,046 2,337
------------------ ----------------
Income from discontinued hotel operations $ 2,258 $ 3,734
================== ================
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.
Sales of $67,000 in the 2002 second quarter and $282,000 in the six month
period were principally attributable to the GuestHouse Suites hotel in
Greenville, South Carolina, prior to its disposition in June 2002.
Page 29
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Expenses. Operating expenses of $66,000 in the 2002 second quarter and
$323,000 for the six months and interest expense of $46,000 for the 2002 second
quarter and $183,000 for the six 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
$1,051,000 in 2003 (including $139,000 in July 2003). HEC is presently in the
development stage, having drilled nine test wells in the Barnett Shale formation
of Johnson County, Texas. After constructing a gas gathering system, HEC
commenced commercial production and sales from three of the nine wells in
February 2003. Currently, eight wells are producing and one well has been
temporarily abandoned. Aggregate production, including royalty owner share and
minor working interest participation, rose to 3.0 million cubic feet of gas per
day during the first week of May 2003, and was approximately 2.6 million cubic
feet of gas per day at August 8, 2003. The reduction in production is due in
part to the natural decline experienced in Barnett Shale wells, coupled with a
temporary slow down in drilling activity between May and July 2003.
In addition to the above, HEC has drilled the Worthington #1 which will
serve as a Texas Railroad Commission Class 1 disposal well and will be used to
accommodate disposed water for HEC as well as third parties. Additional
operations in progress at July 31, 2003 include the drilling of two additional
Barnett Shale wells. HEC anticipates completion operations to commence on these
properties by the middle of August 2003.
HEC currently plans to drill between 10 and 20 wells during the balance of
2003; however, this number may vary based upon a variety of operational and
economic conditions. Whether HEC drills 10 or 20 additional wells this year,
additional capital will be required. HEC currently anticipates that it will
solicit equity contributions from its shareholders in combination with secured
borrowings to meet its capital requirements. Depending on the level of
borrowings, coupled with the ultimate level of well development activity, HEC
may request from its shareholders additional equity contributions over the next
six to eight months of approximately $5,000,000. Based on the Company's current
ownership percentage, if approved by the Company's board of directors, its
equity contribution may total approximately $1,400,000.
HEC holds oil and gas leases covering approximately 34,500 gross and
30,300 net acres of undeveloped leasehold, predominantly in Johnson County,
Texas as of July 31, 2003.
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.
Page 30
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- ----------------
2003 2002 2003 2002
-------- -------- ------ ------
Property management fees .... $ 512 $ 520 $ 998 $ 994
Leasing fees ................ 305 464 690 690
Asset management fees ....... 151 154 303 309
Construction supervision fees 113 128 297 385
-------- -------- ------ ------
Total ..................... $ 1,081 $ 1,266 $2,288 $2,378
======== ======== ====== ======
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.
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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- ----------------
2003 2002 2003 2002
-------- -------- ------ ------
Consulting fees ........................ $ 199 $ 199 $ 398 $ 398
Office space and administrative services 25 22 50 41
-------- -------- ------ ------
Total ................................ $ 224 $ 221 $ 448 $ 439
======== ======== ====== ======
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
$1,051,000 in 2003 (including $139,000 in July 2003). HEC is a private energy
company. The Company owns approximately 28% of HEC and
Page 31
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
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 $4,516,000 and
$8,981,000 for the three month and six month periods ended June 30, 2002,
respectively.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
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 June 30, 2003 (in
thousands):
PAYMENTS DUE DURING THE YEAR ENDING DECEMBER 31,
----------------------------------------------------------------------
2003* 2004 2005 2006 2007 THEREAFTER TOTAL
------- ------- ------- ------- ------- ---------- -------
CONTRACTUAL OBLIGATIONS
Long term debt
Term Loan and Revolving
Credit Facility .......... $ 499 $ 1,052 $ 2,585 $ -- $ -- $ -- $ 4,136
Loan Payable ............... 83 153 -- -- -- -- 236
10% Debentures (face amount) -- -- 6,468 -- -- -- 6,468
Loans payable (Brookwood) .. 430 14,238 413 209 125 21 15,436
Capital lease obligations .... 264 544 -- -- -- -- 808
Separation Agreement ......... 250 3,500 -- -- -- -- 3,750
Operating leases ............. 561 1,076 834 653 538 1,614 5,276
------- ------- ------- ------- ------- ---------- -------
Total .................... $ 2,087 $20,563 $10,300 $ 862 $ 663 $ 1,635 $36,110
======= ======= ======= ======= ======= ========== =======
AMOUNT OF COMMITMENT EXPIRATION
DURING THE YEAR ENDING DECEMBER 31,
----------------------------------------------------------------------
2003* 2004 2005 2006 2007 THEREAFTER TOTAL
------- ------- ------- ------- ------- ---------- -------
COMMERCIAL COMMITMENTS
Employment contracts ......... $ 200 $ 200 $ 50 -- -- -- $ 450
Letters of credit ............ 459 -- -- -- -- -- 459
------- ------- ------- ------- ------- ---------- -------
Total ...................... $ 659 $ 200 $ 50 -- -- -- $ 909
======= ======= ======= ======= ======= ========== =======
--------------------------
* For the six months ending December 31, 2003.
The Company's Term Loan and Revolving Credit Facility and 10% Debentures
require compliance with various loan covenants and financial ratios, which, if
not met, will trigger a default. The Term Loan and Revolving Credit Facility
(and the Amended and Restated Credit Agreement signed in July 2003) 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 credit agreement requires compliance with
various loan covenants and financial ratios, principally a debt service coverage
ratio and a debt to equity ratio.
Page 32
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The principal ratios, as defined in the respective agreements, as of the
end of the first and second quarters in the year ended December 31, 2003 and as
of December 31, 2002 are provided below (dollar amount in thousands):
JUNE 30, MARCH 31, DECEMBER 31,
DESCRIPTION REQUIREMENT 2003 2003 2002
---------------------------- ------------------------------- -------- --------- ------------
TERM LOAN AND REVOLVING
CREDIT FACILITY
Net cash flow, as defined must exceed $3,400............. $ 6,967 $ 5,995 $5,941
Debt service coverage must exceed 1.2 to 1.0......... 1.96 1.77 2.01
Senior leverage must be less than 2.5 to 1.0... 1.81 1.45 1.53
Collateral value coverage must exceed 200% of loan
balance...................... 733% 769% 877%
The Company was in compliance with its loan covenants under the Term Loan
and Revolving Credit Facility and Amended and Restated Credit Agreement for all
interim periods in 2003.
JUNE 30, MARCH 31, DECEMBER 31,
DESCRIPTION REQUIREMENT 2003 2003 2002
---------------------------- --------------------------------- -------- --------- ------------
BROOKWOOD CREDIT AGREEMENT
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......... 2.06 2.22 1.91
Debt to equity must be less than 45% in 2003;
50% in 2002...................... 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 from the lender. The Key Credit Agreement does not contain a
minimum net income covenant for 2003. Brookwood was in compliance with its
covenants as of June 30, 2003, and believes that it will be in compliance with
its covenants for calendar 2003.
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.
Page 33
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 $2,109,000 during the 2003 six
month period to $3,486,000 as of June 30, 2003. The primary sources of cash were
$3,186,000 provided by financing activities and $295,000 provided by operating
activities. The primary uses of cash were an additional investment of $912,000
in HEC and $460,000 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 Term
Loan and Revolving Credit Facility 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 June
30, 2003, Brookwood had approximately $3,090,000 of unused borrowing capacity on
its revolving line of credit facility. In the year ended December 31, 2002 and
six month period ended June 30, 2003, Brookwood paid $250,000 and $500,000,
respectively to the Company under its tax sharing agreement but 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 from the lender. The
loan does not contain a minimum net income covenant for 2003. Brookwood was in
compliance with its covenants as of June 30, 2003, and believes that it will be
in compliance with its covenants for the balance of calendar 2003.
The Brookwood revolving and acquisition facilities, with a combined
balance of $13,451,000 at June 30, 2003, mature in January 2004. Brookwood
intends to extend or refinance these facilities prior to their maturity.
In March 2002, the Company and its HWG, LLC subsidiary entered into the
$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 term loan proceeds were
used in part to repay the $1,500,000 convertible loan from stockholder in March
2002, 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 was in compliance with the loan covenants at June 30, 2003. The
Company borrowed $500,000 under the Revolving Credit Facility in 2002 and
$2,300,000 in 2003 (including $500,000 in July 2003), and therefore has
$1,200,000 of unused borrowing capacity.
In July 2003, the Company and HWG, LLC entered into an amended and
restated credit agreement with First Bank and Trust, N.A. (the "Amended and
Restated Credit Agreement"). The 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 ("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 requires a monthly payment of $48,365. Proceeds
of the new $5,000,000 credit facility ("Special Purpose Credit Facility") are
also restricted and must be used solely to pay a significant portion of the
judgment in the Gotham Partners v. Hallwood Realty Partners, L.P., et al
litigation matter discussed in Note 12. The Special Purpose Credit Facility
bears 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.
Page 34
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Proceeds of the two new facilities must be drawn down prior to August 26,
2003. 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.
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 Hallwood Energy 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, 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 Hallwood 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 is 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. The $6,750,000 judgment amount plus interest due is to
bear interest at the statutory rate of 7% until paid. The Company anticipates
making a $5,000,000 payment against the obligation in August 2003 with proceeds
from the Special Purpose Credit Facility.
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 February 2000, Brookwood acquired the assets of a company in a textile
products-related industry. The purchase price was $1,450,000 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.
Future additional capital investments in HEC may be required. Depending
upon the timing of the investment, an additional borrowing under the Company's
revolving credit facility may be required.
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 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
consolidated financial statements.
Page 35
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
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. 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 36
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 June 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 June 30, 2003, the Company's total outstanding loans and
debentures payable of $27,084,000 were comprised of $10,766,000 of fixed rate
debt and $16,318,000 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 $271,000, 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 June 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 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 37
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
At the Company's Annual Meeting of Stockholders held on May 14, 2003,
stockholders voted on one proposal:
(a) To elect one director to hold office for three years:
Nominee Director Votes For Withheld
---------------- --------- --------
Anthony J. Gumbiner 1,305,783 1,258
5 Other Information
On May 1, 2003, High River Limited Partnership, 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, management, the board of directors of Hallwood Realty, and certain
professional advisors evaluated the offer and advised unitholders to
reject the offer as inadequate. The unsolicited tender offer has
subsequently been extended to September 5, 2003.
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 has engaged Morgan Stanley & Co. Incorporated to
initiate discussions with parties interested in participating in a
transaction with HRP and stating that if Mr. Icahn is interested in
participating in that process, he should contact Morgan Stanley.
The board of directors of Hallwood Realty has authorized its
advisors to continue its evaluation of potential alternatives to the
tender offer, including, without limitation, to initiate 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. Such transaction may include,
without limitation, 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 of any
of its subsidiaries. There can be no assurance, however, that HRP will be
able to generate interest in any such transaction.
Page 38
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
6 Exhibits and Reports on Form 8-K
(a) Exhibits
10.19 Amended and Restated Credit Agreement, dated as of July 28,
2003, among HWG, LLC, as the Borrower, The Hallwood Group
Incorporated, as Parent Guarantor, First Bank, as
Administrative Agent and the Financial Institutions now or
hereafter parties thereto, as the Lenders, regarding a
$3,000,000 Term A Loan, $3,000,000 Special Purpose Advance
Term Loan, $4,000,000 Revolving Credit Facility and a
$5,000,000 Special Purpose Advance Loan, filed herewith.
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 May 16, 2003 - On May 15, 2003 The Hallwood Group
Incorporated issued a press release regarding its results of
operations for the first quarter ended March 31, 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).
Dated July 11, 2003 - On July 8, 2003 the Delaware Court of
Chancery issued its decision after remand from the Delaware
Supreme Court in the litigation captioned, Gotham Partners,
L.P. vs Hallwood Realty Partners, L.P., et al.
Page 39
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: August 14, 2003 By: /s/ Melvin J. Melle
----------------------------------------------
Melvin J. Melle, Vice President
(Principal Financial and Accounting Officer)
Page 40
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
------ -----------------------------------------------------
10.19 Amended and Restated Credit Agreement, dated as of
July 28, 2003, among HWG, LLC, as the Borrower, The
Hallwood Group Incorporated, as Parent Guarantor,
First Bank, as Administrative Agent and the Financial
Institutions now or hereafter parties thereto, as the
Lenders, regarding a $3,000,000 Term A Loan,
$3,000.,000 Special Purpose Advance Term Loan,
$4,000,000 Revolving Credit Facility and a $5,000,000
Special Purpose Advance Loan.
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.
Page 41