================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
MARK ONE
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________________ TO ________________
FOR THE PERIOD ENDED SEPTEMBER 30, 2001 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
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
--- ---
1,424,789 shares of Common Stock, $.10 par value per share,
were outstanding at October 31, 2001.
================================================================================
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
TABLE OF CONTENTS
<Table>
<Caption>
ITEM NO. PART I - FINANCIAL INFORMATION PAGE
- -------- ------------------------------ ----
1 Financial Statements (Unaudited):
Consolidated Balance Sheets as of September 30, 2001
and December 31, 2000.................................................. 3
Consolidated Statements of Operations for the
Nine Months Ended September 30, 2001 and 2000.......................... 5
Consolidated Statements of Operations for the
Three Months Ended September 30, 2001 and 2000......................... 7
Consolidated Statements of Changes in Stockholders' Equity for the
Nine Months Ended September 30, 2001................................... 9
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2001 and 2000.......................... 10
Notes to Consolidated Financial Statements............................... 11
2 Managements's Discussion and Analysis of
Financial Condition and Results of Operations............................ 24
3 Quantitative and Qualitative Disclosures about Market Risk................. 31
PART II - OTHER INFORMATION
1 thru 6 Exhibits, Reports on Form 8-K and Signature Page........................... 32
</Table>
Page 2
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
ASSETS
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2001 2000
------------- ------------
REAL ESTATE
Investments in HRP ............................. $12,318 $ 6,973
Receivables and other assets
Related parties ............................. 242 165
Other ....................................... 69 268
------- -------
12,629 7,406
TEXTILE PRODUCTS
Inventories .................................... 15,914 16,413
Receivables .................................... 14,247 13,170
Property, plant and equipment, net ............. 9,345 9,785
Other .......................................... 2,248 2,111
------- -------
41,754 41,479
OTHER
Cash and cash equivalents ...................... 12,590 901
Deferred tax asset, net ........................ 7,058 5,333
Restricted cash ................................ 960 937
Other .......................................... 610 1,424
------- -------
21,218 8,595
------- -------
TOTAL ....................................... $75,601 $57,480
======= =======
</Table>
See accompanying notes to consolidated financial statements.
Page 3
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2001 2000
------------- ------------
REAL ESTATE
Accounts payable and accrued expenses ............................ $ 769 $ 777
TEXTILE PRODUCTS
Loans payable .................................................... 11,850 12,910
Accounts payable and accrued expenses ............................ 8,496 7,195
-------- --------
20,346 20,105
OTHER
Interest, litigation and other accrued expenses .................. 10,426 3,820
10% Collateralized Subordinated Debentures ....................... 6,690 6,725
Deferred revenue - noncompetition agreement ...................... 6,444 --
Convertible loans from stockholder ............................... 4,000 2,500
Senior Secured Term Loan ......................................... -- 15,094
-------- --------
27,560 28,139
DISCONTINUED OPERATIONS
Net liabilities - Hotels ......................................... 5,105 4,841
Net assets - Energy .............................................. -- (9,196)
-------- --------
5,105 (4,355)
-------- --------
TOTAL LIABILITIES ............................................. 53,780 44,666
REDEEMABLE PREFERRED STOCK
Series B, 250,000 shares issued and outstanding .................. 1,000 1,000
STOCKHOLDERS' EQUITY
Preferred stock, 250,000 shares issued and outstanding as Series B -- --
Common stock, issued 2,396,149 shares at both dates;
outstanding 1,424,789 shares at both dates .................... 240 240
Additional paid-in capital ....................................... 54,452 54,416
Accumulated deficit .............................................. (19,215) (27,924)
Accumulated other comprehensive income ........................... 262 --
Treasury stock, 971,360 shares at both dates; at cost ............ (14,918) (14,918)
-------- --------
TOTAL STOCKHOLDERS' EQUITY .................................... 20,821 11,814
-------- --------
TOTAL ......................................................... $ 75,601 $ 57,480
======== ========
</Table>
See accompanying notes to consolidated financial statements.
Page 4
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------
2001 2000
-------- --------
REAL ESTATE
Fees
Related parties ............................................ $ 4,895 $ 4,079
Other ...................................................... 328 382
Equity income from investments in HRP ......................... 1,702 516
-------- --------
6,925 4,977
Litigation expense ............................................ 2,360 --
Administrative expenses ....................................... 1,426 1,215
Depreciation and amortization ................................. 504 504
-------- --------
4,290 1,719
-------- --------
Income from real estate operations ......................... 2,635 3,258
TEXTILE PRODUCTS
Sales ......................................................... 50,605 55,732
Equity income from joint venture .............................. 577 --
-------- --------
51,182 55,732
-------- --------
Cost of sales ................................................. 42,696 47,352
Administrative and selling expenses ........................... 7,754 7,196
Interest ...................................................... 815 869
-------- --------
51,265 55,417
-------- --------
Income (loss) from textile products operations ............. (83) 315
OTHER
Fees - amortization of deferred revenue ....................... 806 --
Interest on short-term investments and other income ........... 188 77
-------- --------
994 77
Interest expense .............................................. 1,660 2,327
Administrative expenses ....................................... 1,541 1,340
-------- --------
3,201 3,667
-------- --------
Other loss, net ............................................ (2,207) (3,590)
-------- --------
Income (loss) from continuing operations before income taxes 345 (17)
Income taxes ............................................... 927 333
-------- --------
Loss from continuing operations ............................ (582) (350)
</Table>
See accompanying notes to consolidated financial statements.
Page 5
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------
2001 2000
-------- --------
Income (loss) from discontinued operations, net of tax
Income from discontinued operations - Energy ......................... $ 10,734 $ 2,493
Loss from discontinued operations - Hotels ........................... (661) (2,519)
-------- --------
Income (loss) from discontinued operations ........................ 10,073 (26)
Income (loss) before extraordinary loss and loss from cumulative effect
of SFAS No. 133 adoption ............................................. 9,491 (376)
Extraordinary loss from early extinguishment of debt .................... (692) --
-------- --------
Income (loss) before loss from cumulative effect of SFAS No. 133 adoption 8,799 (376)
Loss from cumulative effect of SFAS No. 133 adoption .................... (40) --
-------- --------
NET INCOME (LOSS) ........................................................... 8,759 (376)
Cash dividend on preferred stock ........................................ 50 50
-------- --------
NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS .......................... $ 8,709 $ (426)
======== ========
PER COMMON SHARE
Basic
Loss from continuing operations available to common stockholders ..... $ (0.44) $ (0.28)
Income (loss) from discontinued operations ........................... 7.07 (0.02)
Extraordinary loss from early extinguishment of debt ................. (0.49) --
Loss from cumulative effect of SFAS No. 133 adoption ................. (0.03) --
-------- --------
Net income (loss) available to common stockholders ................ $ 6.11 $ (0.30)
======== ========
Assuming Dilution
Loss from continuing operations available to common stockholders ..... $ (0.44) $ (0.28)
Income (loss) from discontinued operations ........................... 7.07 (0.02)
Extraordinary loss from early extinguishment of debt ................. (0.49) --
Loss from cumulative effect of SFAS No. 133 adoption ................. (0.03) --
-------- --------
Net income (loss) available to common stockholders ................ $ 6.11 $ (0.30)
======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic ................................................................... 1,425 1,425
======== ========
Assuming Dilution ....................................................... 1,425 1,425
======== ========
</Table>
See accompanying notes to consolidated financial statements.
Page 6
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED
SEPTEMBER 30,
------------------------
2001 2000
-------- --------
REAL ESTATE
Fees
Related parties ............................................ $ 1,154 $ 1,220
Other ...................................................... 161 210
Equity income from investments in HRP ......................... 534 167
-------- --------
1,849 1,597
Administrative expenses ....................................... 388 456
Depreciation and amortization ................................. 168 168
Litigation expense ............................................ 95 --
-------- --------
651 624
-------- --------
Income from real estate operations ......................... 1,198 973
TEXTILE PRODUCTS
Sales ......................................................... 14,895 16,426
Equity income from joint venture .............................. 475 --
-------- --------
15,370 16,426
Cost of sales ................................................. 12,720 14,204
Administrative and selling expenses ........................... 2,515 2,420
Interest ...................................................... 245 287
-------- --------
15,480 16,911
-------- --------
Loss from textile products operations ...................... (110) (485)
OTHER
Fees - amortization of deferred revenue ....................... 605 --
Interest on short-term investments and other income ........... 115 13
-------- --------
720 13
Administrative expenses ....................................... 722 389
Interest expense .............................................. 351 780
-------- --------
1,073 1,169
-------- --------
Other loss, net ............................................ (353) (1,156)
-------- --------
Income (loss) from continuing operations before income taxes 735 (668)
Income taxes ............................................... 272 18
-------- --------
Income (loss) from continuing operations ................... 463 (686)
</Table>
See accompanying notes to consolidated financial statements.
Page 7
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED
SEPTEMBER 30,
----------------------
2001 2000
------- -------
Income (loss) from discontinued operations, net of tax
Income from discontinued operations - Energy ............................ $ -- $ 1,156
Loss from discontinued operations - Hotels .............................. (661) (1,103)
------- -------
Income (loss) from discontinued operations .......................... (661) 53
Loss before extraordinary gain ............................................. (198) (633)
Extraordinary gain from early extinguishment of debt ....................... 118 --
------- -------
NET LOSS ....................................................................... (80) (633)
Cash dividend on preferred stock ........................................... -- --
------- -------
NET LOSS AVAILABLE TO COMMON STOCKHOLDERS ...................................... $ (80) $ (633)
======= =======
PER COMMON SHARE
Basic
Income (loss) from continuing operations available to common stockholders $ 0.32 $ (0.48)
Income (loss) from discontinued operations ............................. (0.46) 0.04
Extraordinary gain from early extinguishment of debt .................... 0.08 --
------- -------
Net loss available to common stockholders ............................ $ (0.06) $ (0.44)
======= =======
Assuming Dilution
Income (loss) from continuing operations available to common stockholders $ 0.28 $ (0.48)
Income (loss) from discontinued operations ............................. (0.34) 0.04
Extraordinary gain from early extinguishment of debt .................... 0.06 --
------- -------
Net loss available to common stockholders ............................ $ -- $ (0.44)
======= =======
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic ...................................................................... 1,425 1,425
======= =======
Assuming Dilution .......................................................... 1,973 1,425
======= =======
</Table>
See accompanying notes to consolidated financial statements.
Page 8
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS)
(UNAUDITED)
<Table>
<Caption>
ACCUMULATED
COMMON STOCK ADDITIONAL OTHER
---------------------- PAID-IN ACCUMULATED COMPREHENSIVE
SHARES PAR VALUE CAPITAL DEFICIT INCOME
------ --------- ---------- ----------- -------------
BALANCE, JANUARY 1, 2001 .................... 2,396 $ 240 $ 54,416 $(27,924) $ --
Net income .............................. 8,759
Cash dividend on preferred stock ........ (50)
Pro rata share of stockholders' equity
transactions related to SFAS No. 133
from equity investments:
Cumulative effect ..................... (4,035)
Realized upon disposition
of Hallwood Energy .......................... 36 3,009
Change in fair value of derivatives ......... 1,302
Amortization of interest rate swap .......... (14)
----- ------ -------- -------- --------
BALANCE, SEPTEMBER 30, 2001 ................. 2,396 $ 240 $ 54,452 $(19,215) $ 262
===== ====== ======== ======== ========
<Caption>
TREASURY STOCK TOTAL
------------------- STOCKHOLDERS'
SHARES COST EQUITY
------ ---- -------------
BALANCE, JANUARY 1, 2001 .................... 971 $ (14,918) $ 11,814
Net income .............................. 8,759
Cash dividend on preferred stock ........ (50)
Pro rata share of stockholders' equity
transactions related to SFAS No. 133
from equity investments:
Cumulative effect ..................... (4,035)
Realized upon disposition
of Hallwood Energy .......................... 3,045
Change in fair value of derivatives ......... 1,302
Amortization of interest rate swap .......... (14)
--- --------- --------
BALANCE, SEPTEMBER 30, 2001 ................. 971 $ (14,918) $ 20,821
=== ========= ========
</Table>
See accompanying notes to consolidated financial statements.
Page 9
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------
2001 2000
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) ..................................................... $ 8,759 $ (376)
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
(Increase) decrease in deferred tax asset .......................... (1,725) 170
Equity in net income of HRP ........................................ (1,702) (516)
Depreciation, depletion and amortization ........................... 1,686 1,460
Amortization of deferred revenue - noncompetition agreement ........ (806) --
Extraordinary loss from early extinguishment of debt ............... 692 --
Loss from cumulative effect of SFAS No. 133 adoption ............... 40 --
Amortization of deferred gain from debenture exchange .............. (35) (32)
Net change in other assets and liabilities ......................... 2,678 1,371
Net change in textile products assets and liabilities .............. 426 1,808
Discontinued operations:
Gain from disposition of Hallwood Energy ........................ (8,725) --
Equity in net income of Hallwood Energy ......................... (1,837) (2,493)
Decrease in deferred tax asset .................................. 1,453 --
Net change in other hotel assets and liabilities ................ 754 695
Increase in loss reserve for hotels ............................. 375 --
Depreciation and amortization ................................... -- 2,198
Preferred dividends from Hallwood Energy ........................ -- 11
-------- --------
Net cash provided by operating activities ................... 2,033 4,296
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in textile products property and equipment ................ (582) (1,351)
Payments for textile products business acquisition .................... -- (1,479)
Discontinued operations:
Proceeds from sale of Hallwood Energy common stock ................. 18,000 --
Proceeds from noncompetition agreement ............................. 7,250 --
Capital expenditures for hotels .................................... -- (873)
Purchase of minority shares in energy affiliate .................... -- (465)
Proceeds from sale of Hallwood Energy preferred stock .............. -- 303
Net change in restricted cash for investing activities ............. -- 210
-------- --------
Net cash provided by (used in) investing activities ......... 24,668 (3,655)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from bank borrowings and loans payable ....................... 1,500 4,500
Repayment of bank borrowings and loans payable ........................ (16,154) (4,018)
Payment of preferred stock dividend ................................... (50) (50)
Discontinued operations:
Repayment of hotel bank borrowings and loans payable ............... (308) (655)
-------- --------
Net cash used in financing activities ....................... (15,012) (223)
-------- --------
NET INCREASE IN CASH AND CASH EQUIVALENTS ................................. 11,689 418
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ............................ 901 926
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD .................................. $ 12,590 $ 1,344
======== ========
</Table>
See accompanying notes to consolidated financial statements.
Page 10
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS AND ACCOUNTING POLICIES
Interim Consolidated Financial Statements. The consolidated financial
statements of The Hallwood Group Incorporated (the "Company") 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 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, 2000.
Discontinued Operations. In December 2000, the Company adopted a formal
plan to discontinue and dispose of its hotel operations. In March 2001, the
Company agreed to sell its investment in its Hallwood Energy affiliate,
which represented the Company's energy operations. Accordingly, the former
hotel and energy operations have been reported as a separate component of
operations and the assets and liabilities have been combined and included
in net liabilities (assets) of discontinued operations in the balance
sheet. See also Notes 5 and 6.
New Accounting Pronouncements. Statement of Financial Accounting
Standards No. 133 - Accounting for Derivative Instruments and Hedging
Activities ("SFAS No. 133") was effective for the Company on January 1,
2001. SFAS No. 133 (as amended by SFAS No. 137 and SFAS No. 138)
established accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts and
for hedging activities. All derivatives, whether designated in hedging
relationships or not, are required to be recorded on the balance sheet at
fair value. If the derivative is designated as a fair-value hedge, the
changes in the fair value of the derivative and the hedged item are
recognized in earnings. If the derivative is designated as a cash flow
hedge, changes in the fair value of the derivative are recorded in other
comprehensive income and are recognized in the income statement when the
hedged item affects earnings. These statements define new requirements for
designation and documentation of hedging relationships as well as ongoing
effectiveness assessments in order to use hedge accounting. For a
derivative that does not qualify as a hedge, changes in fair value will be
recognized in earnings.
In connection with its adoption, all derivatives within the Company
were identified pursuant to SFAS No. 133 requirements. The Company
determined it did not directly have any derivative instruments, however,
HRP and Hallwood Energy had such instruments. Accordingly, the Company was
required to record its pro rata share of any impact of these instruments in
accordance with the equity method of accounting.
HRP determined it had one derivative, an interest rate cap. This
derivative was designated as a cash flow hedge. Hedge effectiveness is
measured based on using the intrinsic value of the interest rate cap. All
changes in the fair value of the time value of the cap are recorded
directly to earnings. With the January 1, 2001 adoption of SFAS No. 133,
the Company recorded as an adjustment to income its pro rata share of the
cumulative effect of the adoption of $40,000, or the amount of the
difference between the carrying value as of January 1, 2001 and the
estimated fair value, all of which represented change in time value. On a
quarterly basis during 2001, HRP has recorded changes in the estimated fair
value of the cap in interest expense.
Hallwood Energy determined that all of its oil and gas commodity swaps
and collars, as well as its interest rate swaps should be designated as
cash flow hedges. Since Hallwood Energy's derivatives were designated as
cash flow hedges, changes in the fair value of the derivatives were
recognized in other comprehensive income until the hedged item was
recognized in earnings. Hedge effectiveness was measured based on the
relative changes in the fair value between the derivative contract and the
hedged item over time. Any changes in fair value resulting from
ineffectiveness, as defined by SFAS No. 133, were recognized immediately in
current earnings.
The adoption of SFAS No. 133, as of January 1, 2001, resulted in the
recognition by the Company of its pro rata share of these derivatives, as a
reduction in the carrying value of its investment in Hallwood Energy by
Page 11
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
$4,311,000, with a corresponding change to a component of stockholders'
equity, accumulated other comprehensive loss. During the period through the
May 11, 2001 sale date, $83,000, representing the ineffective portion of
the Company's proportionate share of the cash flow hedges, was charged
against earnings. The accumulated other comprehensive loss was realized
upon disposition of the Company's investment in Hallwood Energy.
Statement of Financial Accounting Standards No. 141 - Business
Combinations ("SFAS No. 141") is effective July 1, 2001 and prohibits
pooling-of-interests accounting for acquisitions. Statement of Financial
Accounting Standards No. 142 - Goodwill and Other Intangible Assets ("SFAS
No. 142") is 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 Company has not yet determined the
effect adopting SFAS No. 142 will have on its financial statements. At
September 30, 2001, the Company reported $1,456,000 of goodwill associated
with the textile products segment and $506,000 of negative goodwill
associated with the real estate segment.
Statement of Financial Accounting Standards No. 144 - Accounting for
the Impairment or Disposal of Long-Lived Assets ("SFAS No. 144") was issued
in August 2001. The provisions of SFAS No. 144 are effective for the
Company beginning on January 1, 2002. The Company has not yet determined
the effect adopting SFAS No. 144 will have on its financial statements.
Other Comprehensive Income. The components of other comprehensive
income for the three months and nine months ended September 30, 2001 are
shown as follows (in thousands):
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2001 SEPTEMBER 30, 2001
------------------ ------------------
Pro rata share of other comprehensive income
from equity investments:
Accumulated other comprehensive income, beginning
of period ................................................... $ -- $ --
Cumulative effect of SFAS No. 133 adoption .................. 276 (4,035)
Realized upon disposition of Hallwood Energy ................ -- 3,009
Change in fair value of derivatives ......................... -- 1,302
Amortization of interest rate swap .......................... (14) (14)
------- -------
Accumulated other comprehensive income, end of period ........... $ 262 $ 262
======= =======
</Table>
Reclassifications. Certain reclassifications have been made to prior
year amounts to conform to the classifications used in the current year.
2. INVESTMENTS IN REAL ESTATE AFFILIATE (DOLLAR AMOUNTS IN THOUSANDS)
<Table>
<Caption>
AS OF SEPTEMBER 30, 2001 AMOUNT AT INCOME FROM INVESTMENTS
------------------------ WHICH CARRIER AT FOR THE NINE MONTHS ENDED
COST OR --------------------------- SEPTEMBER 30,
NUMBER OF ASCRIBED SEPTEMBER 30, DECEMBER 31, -------------------------
DESCRIPTION OF INVESTMENT UNITS VALUE 2001 2000 2001 2000
- ------------------------- --------- -------- ------------- ------------ -------- --------
HALLWOOD REALTY PARTNERS, L.P. ....
- - General partner interest ........ -- $ 8,650 $ 2,101 $ 2,529 $ 86 $ 35
- - Limited partner interest ........ 330,432 8,799 10,217 4,444 1,616 481
-------- -------- -------- -------- --------
Totals ......................... $ 17,449 $ 12,318 $ 6,973 $ 1,702 $ 516
======== ======== ======== ======== ========
</Table>
At September 30, 2001, 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 Hallwood
Realty Partners, L.P. ("HRP") affiliate, respectively. The Company
accounts for its investment in HRP using the equity method of
accounting. The Company's share of the underlying equity in net assets
of
Page 12
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
HRP exceeded its investment, which is being amortized on the straight
line basis over 19 years. The Company also records non-cash adjustments
for the elimination of intercompany profits with a corresponding
adjustment to equity income, its pro rata share of HRP's partners'
capital transactions with corresponding adjustments to additional
paid-in capital and its pro rata share of HRP's comprehensive income.
The cumulative amount of such non-cash adjustments, from the original
date of investment through September 30, 2001, resulted in a $1,639,000
decrease in the carrying value of the HRP investment.
As further discussed in Note 10, the Delaware Court of Chancery
rendered its opinion regarding certain litigation involving the Company
in July 2001. 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 $2,891,000 from August 1995. Accordingly, the
Company accrued the obligation in the second quarter of 2001. The
judgment amount, which represented the court's determination of an
underpayment by the Company for certain limited partnership units
purchased by the Company in 1995 from HRP, was considered additional
purchase price and was added to the Company's investment in the limited
partnership units. The interest component of the judgment has been
recorded as an expense, net of the Company's pro rata share of the
income that will be reported by HRP. 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 is
modified or reversed on appeal.
The carrying value of the Company's general partner interest in HRP
includes the value of intangible rights to provide asset management and
property management services. The Company amortizes that portion of the
general partner interest ascribed to the management rights. For the
nine months ended September 30, 2001 and 2000 such amortization was
$504,000 in each period.
The Company has pledged 30,035 HRP limited partner units to secure
certain capital leases.
The quoted market price and the Company's carrying value per limited
partner unit (AMEX symbol HRY) at September 30, 2001 were $54.00 and
$30.92, respectively. The general partner interest is not publicly
traded.
3. LOANS PAYABLE
Loans payable at the balance sheet dates are detailed below by business
segment (in thousands):
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2001 2000
------------- ------------
Textile Products
Revolving credit facility, prime + .25% or
Libor + 3.00%, due December 2002 ........................ $10,000 $10,937
Acquisition credit facility, prime + 1.00% or
Libor + 3.25%, due December 2002 ........................ 1,000 1,000
Equipment credit facility, prime + .25% or
Libor + 2.75%, due October 2005 ........................ 850 973
------- -------
11,850 12,910
Other
Convertible loans from stockholder, 10% fixed, due at various
dates from March 2005 to March 2006 ..................... 4,000 2,500
Senior Secured Term Loan, 10.25% fixed, repaid May 2001 ..... -- 15,094
------- -------
4,000 17,594
Total ................................................... $15,850 $30,504
======= =======
</Table>
Further information regarding loans payable is provided below:
Page 13
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
Textile Products
Revolving Credit Facility. In December 1999, the Company's Brookwood
subsidiary entered into a revolving credit facility in an amount up to
$17,000,000 with Key Bank National Association ("Key Credit Agreement") to
replace its former credit facility. 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 so defined in the
agreement. As of September 30, 2001, Brookwood had an additional $3,425,000
of borrowing base availability. 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 expires in December 2002 and bears interest at Brookwood's option
of one-quarter percent over prime (7.00% at September 30, 2001) or Libor
plus 3.00% (6.87% at September 30, 2001). The loan agreement contains
covenants, which include maintenance of certain financial ratios,
restrictions on dividends and repayment of debt or cash transfers to the
parent company.
At June 30, 2000 and September 30, 2000, Brookwood was not in
compliance with a coverage ratio covenant contained in the Key Credit
Agreement and subsequently obtained a waiver of the violation. The waiver
provided for an increase of 0.50% in interest rates on the revolving credit
facility and the acquisition credit facility, effective October 2000,
restrictions on the payments to the parent company and certain other
restrictive provisions. Cash dividends and tax sharing payments to the
parent company are contingent upon Brookwood's compliance with the
covenants contained in the loan agreement. At December 31, 2000, Brookwood
was in compliance with its coverage ratio covenant, however, Brookwood did
not achieve its coverage ratio for the 2001 first quarter and obtained a
waiver in April 2001. Brookwood was in compliance with its coverage ratio
covenant for the 2001 second and third quarters.
Acquisition Credit Facility. The Key Credit Agreement includes a
$2,000,000 acquisition revolving credit line. Brookwood borrowed $1,000,000
under this line during the year ended December 31, 2000. This facility
bears interest at Brookwood's option of one percent over prime (7.75% at
September 30, 2001) or Libor plus 3.25% (7.12% at September 30, 2001).
Equipment Credit Facility. The Key Credit Agreement includes a
$2,000,000 equipment revolving credit line. Brookwood borrowed $1,000,000
under this line during the year ended December 31, 2000. This facility
bears interest at Libor + 2.75% (6.62% at September 30, 2001).
The outstanding balance of the combined Key Bank credit facilities at
September 30, 2001 was $11,850,000.
Other
Senior Secured Term Loan. In December 1999, the Company and its HWG,
LLC subsidiary entered into an $18,000,000 credit agreement with First Bank
Texas, N.A. and other financial institutions (the "Senior Secured Term
Loan"). Proceeds were used to repay the 7% Debentures, the energy term loan
and provide working capital. The Senior Secured Term Loan bore interest at
a fixed rate of 10.25%, was scheduled to mature in December 2004, was fully
amortizing and required a monthly payment of $385,000. Collateral was
comprised of (i) 300,397 HRP limited partner units; (ii) 1,440,000 shares
of Hallwood Energy common stock; (iii) a senior lien on the capital stock
of the Hallwood Hotels, Inc. subsidiary; and (iv) a senior lien on the
capital stock of the Brock Suite Hotels, Inc. subsidiary. The Senior
Secured Term Loan contained various financial and non-financial covenants,
including the maintenance of certain financial ratios, and restrictions on
certain new indebtedness and the payment of dividends. The Senior Secured
Term Loan was fully repaid in May 2001 with a portion of the proceeds from
the sale of the Company's investment in Hallwood Energy.
Page 14
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
Convertible Loans from Stockholder. In order to provide sufficient
funds to meet the Company's cash flow requirements and maintain compliance
with the loan covenants contained in the Senior Secured Term Loan, the
Company entered into various loan agreements with an entity associated with
its chairman and principal stockholder, Anthony J. Gumbiner, as indicated
below.
<Table>
<Caption>
LOAN CONVERSION MATURITY
LOAN DATE AMOUNT PRICE DATE
-------------------- -------------- -------------- --------------
March 2000 ......... $ 1,500,000 $ 10.13 March 2005
September 2000 ..... 1,000,000 6.47 September 2005
March 2001 ......... 1,500,000 6.12 March 2006
--------------
Total ......... $ 4,000,000
==============
</Table>
Significant terms for the three loans include: (i) term of five years;
(ii) fixed interest rate of 10%; (iii) interest and principal payments
deferred until maturity date; (iv) unsecured; and (v) convertible into
common stock of the Company after a one-year period from the date of
issuance at a conversion price equal to 115% of the market price on the
date each of the loans was approved by the Company's independent board
members.
4. DEBENTURES
10% Collateralized Subordinated Debentures. The 10% Collateralized
Subordinated Debentures (the "10% Debentures") are listed on The New York
Stock Exchange. For accounting purposes, a pro rata portion of the
unamortized gain attributable to the former 7% Debentures, in the amount of
$353,000, was allocated to the 10% Debentures, and is being amortized over
the term of the 10% Debentures using the effective interest method. As a
result, the effective interest rate for financial reporting is 8.9%.
The 10% Debentures are secured by a junior lien on the capital stock of
the Brookwood, Hallwood Hotels, Inc. and Brock Suite Hotels, Inc.
subsidiaries.
Balance sheet amounts for the 10% Debentures are detailed below (in
thousands):
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
DESCRIPTION 2001 2000
----------- ------------- -----------
10% Debentures (face amount) ................ $6,468 $6,468
Unamortized gain from exchange, net of
accumulated amortization ................. 222 257
------ ------
Totals ................................ $6,690 $6,725
====== ======
</Table>
As a result of certain hotel properties of the Company being placed
into receivership, as further discussed in Note 5, the Company determined
that a technical default occurred under the terms of the Indenture for the
10% Debentures. The Indenture provides that upon the occurrence of the
default, the principal and accrued interest on the 10% Debentures shall
automatically become due and payable. The trustee for the 10% Debentures,
mailed a notice (the "Notice") to debentureholders on July 27, 2001,
informing the holders of the default. The Notice stated that the holders of
a majority of the outstanding principal amount of the 10% Debentures, on
behalf of all holders, may waive the default, rescind and annul the
declaration of acceleration and its consequences. On October 22, 2001, the
Company announced that a solicitation of its bondholders, which began on
September 24, 2001, was completed and that bondholders consented to grant
the waiver and rescind and annul the acceleration. The overdue interest was
subsequently deposited with the Trustee to be paid on November 30, 2001 to
holders of record on November 20, 2001. The payment will consist of
interest that was to have been paid on July 31, 2001 and October 31, 2001,
which the Company was prohibited from paying by the Indenture during the
default, together with default interest on those amounts at the rate of 10%
per annum.
Page 15
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
5. DISCONTINUED OPERATIONS - HOTELS
The Company's hotel segment experienced cash flow difficulties during
2000 due to weaker occupancy and average daily rates. In December 2000, the
Company decided to discontinue 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 hotel segment consisted of three owned
properties and two leased properties. As part of the planned disposition,
the Company evaluated the operations and economic environment in which each
of the hotels operated and determined it was appropriate to record an
impairment of long lived assets of $4,000,000 to their estimated fair
market values. The term loans on the hotel properties are non-recourse and
will be repaid from sales proceeds, if any, or extinguished upon completion
of foreclosure proceedings initiated by the lenders. The capital lease
obligations will be repaid by the sale of leased property or other
considerations.
In January 2001, a receiver was appointed to administer the disposition
of the GuestHouse Suites Plus hotel in Greenville, South Carolina. In
February 2001, the Company signed an Agreement to Terminate Lease with the
landlord of the Holiday Inn and Suites Hotel in Sarasota, Florida. In March
2001, receivers were appointed to administer the disposition of the
GuestHouse Suites Plus hotel in Tulsa, Oklahoma and the Airport Embassy
Suites Hotel in Oklahoma City, Oklahoma, respectively. In June 2001, the
Company transferred the ownership for the Embassy Suites hotel to one of
the lenders. The Company continues to operate the GuestHouse Suites Plus
hotel in Huntsville, Alabama, subject to significant lease concessions by
the landlord, pending the disposition of that leased property. The Company
anticipates that it will not receive any amounts in excess of the
non-recourse debt outstanding.
A summary of the net liabilities as of the balance sheet dates and loss
from discontinued hotel operations are detailed below (in thousands):
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2001 2000
------------- ------------
Loans payable ................................ $ 11,607 $ 29,350
Accounts payable and accrued expenses ........ 2,072 3,140
Capital leases ............................... 1,481 1,774
Properties, net .............................. (7,600) (25,783)
Receivables and other assets ................. (432) (1,639)
Restricted cash .............................. (483) (701)
Deferred tax asset ........................... (1,540) (1,300)
-------- --------
Net liabilities of discontinued operations $ 5,105 $ 4,841
======== ========
</Table>
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
2001 2000 2001 2000
-------- -------- -------- --------
Sales ....................................... $ 1,523 $ 4,360 $ 8,357 $ 14,338
Expenses
Operating expenses ..................... 1,476 4,056 7,369 12,604
Interest expense ....................... 319 674 1,614 2,055
Provision for losses ................... 729 -- 375 --
Deferred income tax benefit ............ (340) -- (340) --
Depreciation and amortization .......... -- 733 -- 2,198
-------- -------- -------- --------
Total expenses ..................... 2,184 5,463 9,018 16,857
-------- -------- -------- --------
Loss from discontinued operations ...... $ (661) $ (1,103) $ (661) $ (2,519)
======== ======== ======== ========
</Table>
Page 16
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
The Company anticipates the recording of extraordinary gains from debt
extinguishment as hotel dispositions are completed. The Company estimates
that the results of discontinued operations from the December 31, 2000
measurement date to the expected final disposition of the various hotels
will be a loss. Accordingly, such amount has been accrued through December
31, 2001, although these operating losses are expected to be offset by
anticipated extraordinary gains from debt extinguishment when the
dispositions are completed.
The Company reported an extraordinary gain from debt extinguishment of
$216,000 (net of $100,000 deferred tax expense) in connection with the
disposition of the Holiday Inn hotel in Florida and the Embassy Suites
hotel in Oklahoma. Dispositions of the three remaining hotels are not yet
completed.
A summary of the non-recourse loans payable is detailed below (in
thousands):
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
DESCRIPTION 2001 2000
----------- ------------- -----------
Term loan, 7.86% fixed, due January 2008 ......... $ 6,514 $ 6,512
Term loan, 8.20% fixed, due November 2007 ........ 5,093 5,093
Term loan, 7.50% fixed, due October 2008 ......... -- 16,742
Term loan, Libor + 7.5%, due October 2005 ........ -- 1,003
------- -------
Total ....................................... $11,607 $29,350
======= =======
</Table>
As previously discussed, certain of the Company's subsidiaries are in
default on each of these term loans and foreclosure procedures have been
initiated by the lenders.
Capital Leases. The Company has guaranteed the capital lease
obligations for the three GuestHouse Suites hotels by pledging 30,035
limited partner units of HRP with a market value of $1,682,000 at September
30, 2001. The combined monthly lease payments are $46,570 and are current
through October 2001. The leases commenced January 2000 and expire December
2004, bear an effective interest rate of 12.18% and have an outstanding
balance of $1,481,000 and $1,774,000 at September 30, 2001 and December 31,
2000, respectively.
6. DISCONTINUED OPERATIONS - ENERGY
On March 30, 2001, Hallwood Energy Corporation ("Hallwood Energy")
announced that it had signed a definitive merger agreement pursuant to
which Pure Resources II, Inc., an indirect wholly owned subsidiary of Pure
Resources, Inc., agreed to acquire all the outstanding common stock of
Hallwood Energy at a price of $12.50 per share and all the outstanding
shares of Series A Cumulative Preferred Stock of Hallwood Energy at a price
of $10.84 per share. The all-cash transaction was structured as a first
step tender offer followed by a cash merger to acquire all remaining shares
of Hallwood Energy. The Company also agreed to tender all of its shares of
common stock in the tender offer and granted to Pure an irrevocable proxy
to vote in favor of the merger, on the same terms as provided in the merger
agreement. Pure commenced its tender offer on April 10, 2001, with an
expiration date of May 8, 2001. On May 9, 2001, Pure announced that it had
successfully completed its initial tender offer, and had acquired
approximately 85% of the Hallwood Energy common stock and 78% of the
Hallwood Energy preferred stock. The Company received $18,000,000 for the
tender of its 1,440,000 shares of common stock on May 11, 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 (described below) without the prior written consent
of Pure and Hallwood Energy. 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
Page 17
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
not, directly or indirectly, engage in oil and gas activities in certain
geographic areas without the prior consent of Pure. The Company has also
agreed to keep Hallwood Energy's confidential and proprietary information
strictly confidential. For six months after any payment is made for any
shares of Hallwood Energy stock pursuant to the offer, neither the Company
nor any of its affiliates will, directly or indirectly, hire any person who
is presently an employee of Hallwood Energy or any existing or future
affiliate of Hallwood Energy (whether or not he or she remains an affiliate
of Hallwood Energy), unless such employee has been involuntarily terminated
by Hallwood Energy.
A summary of the net assets as of the balance sheet dates and income
from discontinued energy operations, are detailed below (in thousands):
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2001 2000
------------- ------------
Investment in Hallwood Energy ......................... $ -- $(7,403)
Deferred tax asset .................................... -- (1,793)
------- -------
Net (assets) of discontinued energy operations .... $ -- $(9,196)
======= =======
</Table>
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30
----------------------- ------------------------
DESCRIPTION 2001 2000 2001 2000
----------- -------- -------- -------- --------
Gain from disposition of investment in Hallwood Energy ..... $ -- $ -- $ 8,725 $ --
Equity income from investment in Hallwood Energy ........... -- 1,156 1,837 2,493
Deferred federal income tax benefit ........................ -- -- 672 --
Current federal income tax expense ......................... -- -- (400) --
State income tax expense ................................... -- -- (100) --
-------- -------- -------- --------
Income from discontinued energy operations ............. $ -- $ 1,156 $ 10,734 $ 2,493
======== ======== ======== ========
</Table>
The Company began amortizing the deferred revenue from the
noncompetition agreement in the amount of $7,250,000, over a three-year
period commencing June 1, 2001. The amortization is being reported as fee
income in the "Other" section of the statement of operations.
Prior to the disposition of its common stock interest in Hallwood
Energy, the Company accounted for its investment using the equity method of
accounting, as the Company exercised significant influence over Hallwood
Energy's operational and financial policies. The Company's share of the
underlying equity in net assets of Hallwood Energy exceeded its investment
by $4,391,000, which was being amortized at a rate which approximated the
depletion rate of Hallwood Energy's reserves. In addition to recording its
share of Hallwood Energy's net income available to common stockholders, the
Company also recorded its preferred dividends prior to the February 2000
sale of its preferred stock. The Company also recorded its pro rata share
of any capital transactions.
Page 18
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
7. INCOME TAXES
The following is a schedule of income tax expense for (in thousands):
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ----------------------
2001 2000 2001 2000
------- ------- ------- -------
CONTINUING OPERATIONS
Federal
Deferred tax ........................... $ 206 $ -- $ 740 $ 170
Current tax ............................ 36 11 23 38
------- ------- ------- -------
Sub-total .......................... 242 11 763 208
State ....................................... 30 7 164 125
------- ------- ------- -------
Total .............................. $ 272 $ 18 $ 927 $ 333
======= ======= ======= =======
DISCONTINUED OPERATIONS
Federal
Deferred tax (benefit) ................. $ (340) $ -- $(1,012) $ --
Current tax ............................ -- -- 400 --
------- ------- ------- -------
Sub-total .......................... (340) -- (612) --
State ....................................... -- -- 100 --
------- ------- ------- -------
Total .............................. $ (340) $ -- $ (512) $ --
======= ======= ======= =======
EXTRAORDINARY ITEM
Federal
Deferred tax ........................... $ 100 $ -- $ 100 $ --
======= ======= ======= =======
</Table>
The amount of the deferred tax asset (net of valuation allowance) for
the Company's continuing operations was $7,058,000 at September 30, 2001.
The deferred tax asset arises principally from the anticipated utilization
of the Company's NOLs and tax credits from the implementation of various
tax planning strategies, 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. The Company also had a deferred tax asset of
$1,540,000 associated with its discontinued hotel operations as of
September 30, 2001, principally due to the anticipated utilization of the
Company's NOLs from the disposition of certain hotel properties.
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 19
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
8. SUPPLEMENTAL DISCLOSURES TO THE CONSOLIDATED STATEMENTS OF CASH FLOWS
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
DESCRIPTION 2001 2000
----------- ------- -------
Supplemental schedule of non-cash investing and financing activities:
Pro rata share of stockholders' equity transactions related to SFAS
No. 133 of equity investments:
Cumulative effect ................................................. $(4,035) --
Realized upon disposition of Hallwood Energy ...................... 3,009 --
Change in fair value of derivatives ............................... 1,302 --
Amortization of interest rate swap ................................ (14) --
------- -------
Accumulated other comprehensive income ......................... $ 262 --
======= =======
Litigation judgment - additional investment in HRP
units, accrued but not paid ....................................... $ 3,417 --
Other
HRP ............................................................... $ -- $ 291
Hallwood Energy ................................................... 36 35
Supplemental disclosures of cash payments:
Interest paid ......................................................... $ 2,375 $ 4,571
Income taxes paid ..................................................... 723 321
</Table>
9. COMPUTATION OF EARNINGS PER SHARE
The following table reconciles the Company's income (loss) from
continuing operations to income (loss) from continuing operations available
to common stockholders assuming dilution, and the number of common shares
used in the calculation of net income for the basic and assumed dilution
methods (in thousands):
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30
--------------------- ----------------------
DESCRIPTION 2001 2000 2001 2000
----------- ------- ------- ------- -------
INCOME AVAILABLE TO COMMON STOCKHOLDERS
Income (loss) from continuing operations .............. $ 463 $ (686) $ (582) $ (350)
Less dividend on preferred stock ...................... -- -- (50) (50)
------- ------- ------- -------
Income (loss) from continuing operations - basic ...... 463 (686) (632) (400)
Interest from assumed loan conversions ................ 87 -- -- --
------- ------- ------- -------
Income (loss) from continuing operations,
available to common stockholders .................. $ 550 $ (686) $ (632) $ (400)
======= ======= ======= =======
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic ................................................. 1,425 1,425 1,425 1,425
Assumed issuance of shares from loan conversions ...... 548 -- -- --
Assumed issuance of shares from exercise of
stock options .................................... -- -- -- --
Assumed repurchase of shares from stock options
proceeds .......................................... -- -- -- --
------- ------- ------- -------
Assuming dilution ..................................... 1,973 1,425 1,425 1,425
======= ======= ======= =======
</Table>
Page 20
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
The impact of the convertible loans from stockholder was anti-dilutive
for the periods other than the three month period ended September 30, 2001,
due to the loss from continuing operations.
10. LITIGATION, CONTINGENCIES AND COMMITMENTS
Reference is made to Notes 9 and 18 to the consolidated financial
statements contained in Form 10-K for the year ended December 31, 2000.
Beginning in 1997, the Company and its HRP affiliate have been
defendants in two lawsuits that were brought by Gotham Partners, L.P. in
the Delaware Court of Chancery. The first suit filed in February 1997,
styled Gotham Partners, L.P. v. Hallwood Realty Partners, L.P. and Hallwood
Realty Corporation (C.A. No. 15578), sought access to certain books and
records of HRP and was subsequently settled, allowing certain access. The
suit was dismissed in April 2001. The second action, filed in June 1997,
styled Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., et al (C.A.
No. 15754), against the Company, HRP, HRC and the directors of HRC, alleges
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 is 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 in the amount of $3,417,000, plus pre-judgment interest of
approximately $2,891,000 from August 1995 to HRP. The amount represents
what the court determined was an underpayment by the Company. The court's
judgment is 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. Those appeals are
pending. 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 is modified or reversed on appeal.
In February 2000, HRP filed a lawsuit in the United States District
Court for the Southern District of New York styled Hallwood Realty
Partners, L.P. v. Gotham Partners, L.P., et al (Civ. No. 00 CV1115)
alleging violations of the Securities Exchange Act of 1934 by certain
purchasers of HRP's limited partnership units, including Gotham Partners,
L.P., Gotham Partners, III L.P., Private Management Group, Inc., Interstate
Properties, Steven Roth and EFO Realty, Inc., by virtue of those
purchasers' misrepresentations and/or omissions in connection with filings
required under the Securities Exchange Act of 1934. The complaint further
alleged that the defendants, by acquiring more than 15% of the outstanding
HRP limited partnership units, have triggered certain rights under its Unit
Purchase Rights Agreement, for which HRP was seeking declaratory relief.
HRP sought various forms of relief, including declaratory judgments,
divestiture, corrective disclosures, a "cooling-off" period and damages,
including costs and disbursements. Discovery was completed in December 2000
and trial was held in February 2001. In February 2001, the Court rendered a
decision in favor of the defendants and the Court ordered the complaint
dismissed. HRP filed a Notice of Appeal in March 2001 with respect to the
dismissal of the complaint. Both parties have filed briefs with the Second
Circuit, but the oral argument has not been scheduled.
In December 1999, the Company deposited $900,000 into an escrow account
to secure the maximum amount which could be payable by the Company in a
lawsuit brought by a former promissory note holder. The
Page 21
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
trial was held in June 2001 in the Delaware Court of Chancery. The parties
submitted post-trial briefings in September 2001. Management is not able to
predict the outcome of the litigation.
The Company is currently a defendant in two lawsuits in connection with
the disposition of certain hotel properties. The plaintiffs allege
violations of franchise and lease agreements and seek damages of
approximately $1,500,000. Management believes that the claims are without
merit and intend to defend the cases vigorously. Management is not able to
predict the outcome of the litigation.
In December 1999 the Company distributed certain assets and incurred a
contingent obligation, under the agreement to separate the interests of its
former president and director (the "Separation Agreement"). The contingent
obligation in the amount of $3,054,000 at September 30, 2001, is the
present value of the remaining payments under the Separation Agreement and
is included in other accrued expenses. Interest on the contingent
obligation has been imputed at 12.75% and amounted to $199,000 and $205,000
for the nine months ended September 30, 2001 and 2000, respectively.
In February 2000, the Company, through a wholly owned subsidiary,
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.
No amounts are currently due under the contingency portion of the purchase
agreement.
11. SEGMENT AND RELATED INFORMATION
The following represents the Company's reportable segment operations
for the nine months ended September 30, 2001 and 2000, respectively (in
thousands):
<Table>
<Caption>
REAL TEXTILE DISCONTINUED CONSOL
ESTATE PRODUCTS OTHER OPERATIONS -IDATED
-------- -------- -------- ------------ ----------
NINE MONTHS ENDED SEPTEMBER 30, 2001
Total revenue from external sources ....... $ 6,925 $ 51,182 $ 994 $ 59,101
======== ======== ======== ========
Operating income (loss) ................... $ 2,635 $ (83) $ 2,552
======== ========
Unallocable expenses, net ................. $ (2,207) (2,207)
======== --------
Income from continuing operations
before income taxes .................... $ 345
========
Income from discontinued operations ....... $ 10,073 $ 10,073
======== ========
NINE MONTHS ENDED SEPTEMBER 30, 2000
Total revenue from external sources ....... $ 4,977 $ 55,732 $ 77 $ 60,786
======== ======== ======== ========
Operating income .......................... $ 3,258 $ 315 $ 3,573
======== ========
Unallocable expenses, net ................. $ (3,590) (3,590)
======== --------
Loss from continuing operations
before income taxes .................... $ (17)
========
Loss from discontinued operations ......... $ (26) $ (26)
======== ========
</Table>
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, 2000 annual report. The total assets for the Company's
operating segments have not materially changed since the December 31, 2000
annual report, other than the reclassification of the Company's investment
in energy assets to discontinued operations.
Page 22
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)
12. STOCKHOLDER LOANS
During 2000, the Company borrowed a total of $2,500,000 from its
chairman and principal stockholder and an additional $1,500,000 in March
2001. Several factors contributed to the Company's cash flow needs,
including difficulties experienced by the Company's hotel operations and
restrictions on the availability of distributions and payments from
Brookwood. In response to these matters, management decided to discontinue
its hotel operations and completed the sale of its Hallwood Energy
investment during 2001. Management believes that these strategies allow the
Company to return to profitability with sufficient liquidity. In addition,
the principal stockholder committed to loan the Company additional funds
during the balance of 2001, if required.
Page 23
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 a net loss of $80,000 for the third quarter ended
September 30, 2001, compared to a net loss of $633,000 in 2000. Revenue
from continuing operations for the 2001 third quarter was $17,939,000,
compared to $18,036,000 in 2000. Net income (loss) and revenue from
continuing operations for the nine months was $8,759,000 and $59,101,000,
compared to $(376,000) and $60,786,000 in 2000, respectively.
Following is an analysis of the results of continuing operations by the
real estate and textile products business segments, and the discontinued
operations for the hotel and energy business segments.
REAL ESTATE
The real estate segment reported income of $1,198,000 for the third
quarter and $2,635,000 for the nine month period of 2001, compared to
income of $973,000 and $3,258,000 in 2000, respectively.
Revenues. Fee income of $1,315,000 for the 2001 third quarter decreased
by $115,000, or 8%, from $1,430,000 in 2000. Fee income of $5,223,000 for
the nine months increased by $762,000, or 17%, from $4,461,000 for similar
period in 2000. Fees are derived from the Company's asset management,
property management, leasing and construction supervision services provided
to its Hallwood Realty Partners, L.P. affiliate, a real estate master
limited partnership ("HRP") and various third parties. The increase was due
primarily to higher leasing fees in the 2001 periods.
Equity income from investments in HRP represents the Company's
recognition of its pro rata share of net income reported by HRP, adjusted
for the elimination of intercompany income and amortization of negative
goodwill. For the 2001 third quarter, the Company reported equity income of
$534,000, compared to $167,000 in 2000. For the nine months, income was
$1,702,000, compared to $516,000 in 2000. The increases resulted
principally from gains from property sales by HRP in the 2001 first
quarter. Litigation costs reported by HRP decreased in the 2001 third
quarter due to the conclusion of the trial discussed below. The 2001 equity
income was exclusive of the Company's $108,000 pro rata share of HRP's
extraordinary loss from early extinguishment of debt and its $40,000 pro
rata share of HRP's loss from cumulative effect of SFAS No. 133 adoption,
both of which are reported separately.
Expenses. Litigation expense of $95,000 and $2,360,000 was recorded in
the 2001 third quarter and nine month periods, respectively. As further
discussed in Note 10, the Delaware Court of Chancery rendered its opinion
regarding certain litigation involving the Company in July 2001. 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
$2,893,000. Accordingly, the Company accrued the obligation as of June 30,
2001. The judgment amount, which represented the court's determination of
an underpayment by the Company for certain limited partnership units
purchased by the Company in 1995 from HRP, was considered additional
purchase price and was added to the Company's investment in the limited
partnership units. The interest component of the judgment has been recorded
as an expense, net of the Company's pro rata share of the income that will
be reported by HRP. In the 2001 third quarter, the Company recorded $95,000
of post-judgment interest expense. The Company paid $6,405,000 (including
post-judgment interest) to HRP in October 2001.
Administrative expenses of $388,000 decreased by $68,000, or 15%, in
the 2001 third quarter, compared to $456,000 in 2000. For the nine months,
the increase was $211,000 to $1,426,000, from $1,215,000 in 2000. The
fluctuations were primarily attributable to the payments of commissions to
third party brokers associated with leasing income.
Amortization expense of $168,000 for the third quarter, and $504,000
for the nine months in both the 2001 and 2000 periods relate to the
Company's general partner investment in HRP to the extent allocated to
management rights.
Page 24
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
TEXTILE PRODUCTS
The textile products segment reported losses of $110,000 and $83,000
for the third quarter and nine month periods of 2001, compared to a loss of
$485,000 and income of $315,000 in 2000, respectively.
Revenue. Sales of $14,895,000 decreased $1,531,000, or 9%, in the 2001
third quarter, compared to $16,426,000 in the 2000 quarter. The comparative
nine month sales decreased by $5,127,000, or 9%, to $50,605,000 from
$55,732,000 in the 2000 period. The sales decreases were principally in the
distribution business as a result of lower overall demand and the continued
trend of U.S. customers moving production out of the country. The decreases
were partially offset by increased revenues from new customers and new
production processes.
Equity income from joint venture was $475,000 and $577,000 in the 2001
third quarter and nine month periods, respectively. During 2000, Brookwood
formed a joint venture with an unrelated third party that is also in a
textile-related industry. The joint venture is 50%-owned by each party,
with operating and management decision making, and venture profits and
losses shared equally by both parties.
Expenses. Cost of sales of $12,720,000 decreased $1,484,000, or 10%, in
the 2001 third quarter, from $14,204,000 in the 2000 quarter. The
comparative nine month cost of sales of $42,696,000 decreased by
$4,656,000, or 10%, compared to $47,352,000 in 2000. The decreases in cost
of sales were principally the result of the decreases in sales. The higher
gross profit margin for the 2001 third quarter (14.6% versus 13.5%) and the
nine month periods (15.6% versus 15.0%) resulted from higher margin sales
to new customers and from new production processes.
Administrative and selling expenses of $2,515,000 increased by $95,000,
or 4%, in the 2001 third quarter from $2,420,000 for the comparable 2000
period. The nine month amount of $7,754,000 increased by $558,000, or 8%,
from $7,196,000 for the comparable 2000 period. The increases resulted from
costs incurred in a brief strike at the dying and finishing plant and the
development of new products and business.
Interest expense of $245,000 decreased by $42,000, or 15%, for the 2001
third quarter from $287,000 in 2000, due to lower interest rates. The nine
month amount of $815,000 decreased by $54,000, from $869,000 for the
comparable 2000 period.
OTHER
The other segment reported a loss of $353,000 and $2,207,000 for the
third quarter and nine month periods of 2001, compared to a loss of
$1,156,000 and $3,590,000 in 2000, respectively.
Revenue. Fee revenue of $605,000 in the 2001 third quarter and $806,000
for the nine month period is attributable to the amortization of deferred
revenue resulting from the $7,250,000 noncompetition fee received in
connection with the sale of the Company's investment in Hallwood Energy. It
is being amortized over a three-year period commencing June 1, 2001.
Interest on short-term investments and other income increased by
$102,000 to $115,000 for the 2001 third quarter from $13,000 in 2000. For
the nine months, the amounts increased by $111,000 to $188,000 from
$77,000. The increases resulted from increased interest income on invested
funds from the sale of Hallwood Energy.
Expenses. Interest expense in the amount of $351,000 for the 2001 third
quarter decreased by $429,000 from the prior year amount of $780,000. For
the nine months, interest expense decreased by $667,000 to $1,660,000 from
$2,327,000 in 2000. The decreases were primarily due to the principal
amortization on the Senior Secured Term Loan and its payoff in May, 2001
with a portion of the proceeds from the sale of Hallwood Energy.
Page 25
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Administrative expenses of $722,000 for the 2001 third quarter
increased by $333,000, from the prior-year amount of $389,000. For the nine
months, administrative expenses increased by $201,000 to $1,541,000 from
$1,340,000 in 2000. The increases are primarily attributable to consulting
and other professional fees.
INCOME TAXES
Income taxes from continuing operations was $272,000 for the 2001 third
quarter, compared to $18,000 in 2000. The 2001 third quarter included a
$206,000 non cash federal deferred charge, a $36,000 federal charge and
$30,000 for state taxes. The 2000 quarter included an $11,000 federal
current charge and $7,000 for state taxes. Income taxes were $927,000 for
the 2001 nine months period, compared to expense of $333,000 in 2000. 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.
For its discontinued operations, the Company recorded a deferred income
tax benefit of $340,000 in the 2001 third quarter. For the nine months the
Company recorded net tax benefit of $512,000, including a deferred income
tax benefit of $1,012,000, principally due to the utilization of the
Company's NOL's from the sale of its investment in Hallwood Energy, a
federal current charge of $400,000 and $100,000 for state taxes.
As of September 30, 2001, the Company had approximately $75,000,000 of
tax net operating loss carryforwards ("NOLs") and temporary differences to
reduce future federal income tax liability. Based upon the Company's
expectations and available tax planning strategies, management has
determined that taxable income will more likely than not be sufficient to
utilize approximately $25,290,000 of the NOLs prior to their ultimate
expiration in the year 2011.
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.
Page 26
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
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 hotel segment consisted of three owned properties and two
leased properties. In accordance with accounting standards for reporting
discontinued operations, hotel operations 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 months and nine months ended September 30, 2001 and 2000 are
presented below:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30
------------------------ ------------------------
DESCRIPTION 2001 2000 2001 2000
----------- -------- -------- -------- --------
Sales ............................... $ 1,523 $ 4,360 $ 8,357 $ 14,338
Expenses
Operating expenses .............. 1,476 4,056 7,369 12,604
Interest expense ................ 319 674 1,614 2,055
Provision for losses ............ 729 -- 375 --
Deferred income tax benefit ..... (340) -- (340) --
Depreciation and amortization ... -- 733 -- 2,198
-------- -------- -------- --------
Total expenses .............. 2,184 5,463 9,018 16,857
-------- -------- -------- --------
Loss from discontinued operations $ (661) $ (1,103) $ (661) $ (2,519)
======== ======== ======== ========
</Table>
Revenue. Sales of $1,523,000 in the 2001 third quarter decreased by
$2,837,000, from the year-ago amount of $4,360,000. For the nine months,
the decrease was $5,981,000 to $8,357,000, compared to $14,338,000 in 2000.
The decreases were primarily due to the February 2001 termination of the
lease for the Longboat Key Holiday Inn and Suites hotel in Sarasota,
Florida, and the June 2001 transfer of hotel ownership to one of the
lenders for the Embassy Suites hotel in Oklahoma City, Oklahoma.
Expenses. Operating expenses of $1,476,000 for the 2001 third quarter
were down $2,580,000 from $4,056,000 in 2000. For the nine months,
operating expenses decreased by $5,235,000 to $7,369,000 from $12,604,000
in 2000. The decreases were primarily due to the aforementioned disposition
of the Longboat Key Holiday Inn and Oklahoma City Embassy Suites hotels.
Interest expense of $319,000 in the 2001 third quarter and $1,614,000 for
the nine months were down compared to the 2000 amounts of $674,000 and
$2,055,000, respectively, due to the disposition of the Embassy Suites
hotel. Receivers have been appointed for the two remaining hotels owned by
the Company, although foreclosures and/or dispositions have not yet been
completed. The Company continues to operate the GuestHouse Suites hotel in
Huntsville, Alabama subject to significant lease concessions granted by the
landlord. Depreciation and amortization expense was not recorded for the
2001 periods due to the classification of the hotel operations as a
discontinued operation. The expense for the 2000 third quarter and nine
month periods were $733,000 and $2,198,000, respectively.
The Company anticipates the recording of extraordinary gains from debt
extinguishment as hotel dispositions are completed. The Company estimates
that the results of discontinued operations from the December 31, 2000
measurement date to the expected final disposition of the various hotels
will be a loss. Accordingly, such amount has been accrued through December
31, 2001, although these operating losses are expected to be offset by
anticipated gains from debt extinguishment when the dispositions are
completed.
The Company reported an extraordinary gain from debt extinguishment of
$216,000 (net of $100,000 deferred tax expense) in connection with the
disposition of the Holiday Inn hotel in Florida and the Embassy Suites
hotel in Oklahoma. Dispositions of the three remaining hotels are not yet
completed.
Page 27
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
DISCONTINUED OPERATIONS - ENERGY
In March 2001, the Company agreed to sell its investment in its
Hallwood Energy affiliate, which represented the Company's energy
operations, to Pure Resources II, an indirect subsidiary of Pure Resources,
Inc., subject to Hallwood Energy's shareholder approval which was obtained
in May 2001. Accordingly, energy operations have been segregated from the
Company's continuing operations and reported as a single line item - Income
from Discontinued Operations. Operations for the three months and nine
months ended September 30, 2001 and 2000 are presented below:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30
----------------------- ------------------------
DESCRIPTION 2001 2000 2001 2000
----------- -------- -------- -------- --------
Gain from disposition of investment in Hallwood Energy $ -- $ -- $ 8,725 $ --
Equity income from investment in Hallwood Energy ..... -- 1,156 1,837 2,493
Deferred federal income tax benefit .................. -- -- 672 --
Current federal income tax expense ................... -- -- (400) --
State income tax expense ............................. -- -- (100) --
-------- -------- -------- --------
Income from discontinued operations .............. $ -- $ 1,156 $ 10,734 $ 2,493
======== ======== ======== ========
</Table>
The Company received $18,000,000 for the tender of its 1,440,000 shares
of common stock of Hallwood Energy on May 11, 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. The Company began amortizing the deferred revenue of $7,250,000 from
the noncompetition agreement over a three-year period commencing June 1,
2001. The amortization is reported as fee income in the "Other" section of
the statement of operations.
The equity income in the 2001 first quarter from investment in Hallwood
Energy represents the Company's pro rata share (15%) of income available to
common stockholders, and amortization of negative goodwill. Hallwood
Energy's income increased significantly in the 2001 periods, compared to
2000, as a result of higher oil and gas prices and savings associated with
the disposition of certain non-strategic properties and the completion of
the Energy Consolidation. The 2001 amounts reflect earnings through the
sale date of May 11, 2001.
The Company recorded a deferred income tax benefit of $3,586,000 in the
2001 first quarter, principally due to the anticipated utilization of the
Company's NOL's from the sale of its investment in Hallwood Energy. In the
2001 second quarter, the Company recorded a deferred tax expense of
$2,914,000, current federal tax expense of $400,000 and state taxes of
$100,000, at the consummation of the sale.
EXTRAORDINARY GAIN (LOSS) FROM EARLY EXTINGUISHMENT OF DEBT
In the 2001 third quarter, the Company recognized an extraordinary gain
from early extinguishment of debt of $118,000, of which $216,000 was
attributable to the transfer of the ownership rights to the Oklahoma City
Embassy Suites hotel to the mezzanine lender, partially offset by a $98,000
loss from the recognition of the Company's pro rata share of an
extraordinary loss reported by HRP. In the 2001 nine months, the Company
recognized an extraordinary loss from early extinguishment of debt of
$692,000, including the write off of $800,000 in unamortized deferred loan
costs associated with the repayment of the Senior Secured Term Loan, the
aforementioned $216,000 gain associated with its hotels and $108,000 from
its share of HRP's extraordinary loss.
Page 28
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 unrestricted cash and cash equivalents at September 30,
2001 totaled $12,590,000.
As discussed in Note 6, the Company tendered its 1,440,000 shares of
common stock in Hallwood Energy, pursuant to a tender offer and merger
agreement announced on March 30, 2001. The Company received $18,000,000 for
the tender of its shares on May 11, 2001 and received an additional
$7,250,000, pursuant to the terms of a noncompetition agreement upon
completion of the merger in June 2001.
The Senior Secured Term Loan, with a remaining balance of $14,059,000,
was fully repaid in May 2001 with a portion of the proceeds from the sale
of the Hallwood Energy investment.
During 2000, the Company borrowed a total of $2,500,000 from its
chairman and principal stockholder and an additional $1,500,000 in March
2001. Several factors contributed to the Company's cash flow needs,
including difficulties experienced by the Company's hotel operations and
restrictions on the availability of distributions and tax sharing payments
from Brookwood. In response to these matters, management decided to
discontinue its hotel operations in December 2000 and sold its Hallwood
Energy investment in May 2001. Management believes that these strategies
will allow the Company to return to profitability with sufficient
liquidity. In addition, the principal stockholder committed to loan the
Company additional funds during the balance of 2001, if required.
As a result of certain hotel properties of the Company being placed
into receivership, the Company determined that a technical default occurred
under the terms of the Indenture for the 10% Debentures. The Indenture
provides that upon the occurrence of the default, the principal and accrued
interest on the 10% Debentures shall automatically become due and payable.
The trustee for the 10% Debentures, mailed a notice (the "Notice") to
debentureholders on July 27, 2001, informing the holders of the default.
The Notice stated that the holders of a majority of the outstanding
principal amount of the 10% Debentures, on behalf of all holders, may waive
the default, rescind and annul the declaration of acceleration and its
consequences. On October 22, 2001, the Company announced that a
solicitation of its bondholders, which began September 24, 2001, was
completed and the bondholders consented to grant the waiver and rescind and
annul the acceleration. The overdue interest was subsequently deposited
with the trustee to be paid on November 30, 2001 to holders of record on
November 20, 2001. The payment will consist of the interest that was to
have been paid on July 31, 2001 and October 31, 2001, which the Company was
prohibited from paying by the Indenture during the default, together with
default interest on those amounts at the rate of 10% per annum. See also
Note 5.
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 $2,891,000.
Accordingly, the Company accrued this obligation as of June 30, 2001. The
court's judgment is 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. Those
appeals are pending. 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 judgement is modified or reversed on
appeal.
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 30,035 of its HRP limited
partnership units to secure certain capital leases. The Company's real
estate subsidiaries and 300,397 HRP units are unencumbered, which are
available to serve as collateral for any new credit facilities.
Brookwood maintains a revolving line of credit facility which is
collateralized by accounts receivable, certain inventory and equipment, and
separate acquisition and equipment credit facilities. At September 30,
2001, Brookwood had $3,425,000 of unused borrowing capacity on its
revolving line of credit. In the year ended December 31, 2000, the Company
received a cash dividend of $400,000 from Brookwood and tax sharing
Page 29
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
payments of $200,000. Future cash dividends and tax sharing payments to the
parent company are contingent upon Brookwood's compliance with the
covenants contained in the amended loan agreement.
Although Brookwood was in compliance with its loan covenants at
December 31, 2000. Brookwood did not achieve its cash flow coverage ratio
covenant for the 2001 first quarter. In April 2001, Brookwood obtained a
waiver of this violation. Brookwood was in compliance with its coverage
ratio covenant for the 2001 second and third quarters.
In February 2000, the Company, through a wholly owned subsidiary,
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.
As of September 30, 2001, no contingent amounts were owed.
The Company's hotel segment experienced cash flow difficulties during
2000, due to weaker occupancy and average daily rates at several hotels. In
October 2000, the Company discontinued payments on the first mortgages for
the Greenville and Tulsa GuestHouse Suites Plus hotels and the lease rent
on the Huntsville GuestHouse Suites Plus hotel, and initiated discussions
with the parties regarding loan or lease modifications. 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 anticipates that
in disposing of the hotels, it will not receive any amounts in excess of
the debt outstanding on the properties, but that the non-recourse debt
associated with the properties will be extinguished. Payments on the three
capital leases continue to be made by the Company or the hotel subsidiaries
while operations continue during the disposition period.
As a result of the receipt of cash proceeds from the sale of its
Hallwood Energy investment and its ability to obtain new credit facilities,
the Company believes it has sufficient liquidity to meet its continuing
obligations.
FORWARD-LOOKING STATEMENTS
In the interest of providing stockholders with certain information
regarding the Company's future plans and operations, certain statements set
forth in this Form 10-Q 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
and market new and existing 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 30
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 nine months ended September 30, 2001, other than the elimination
of market risks associated with its former Hallwood Energy affiliate.
The Company is exposed to market risk due to fluctuations in interest
rates. The Company utilizes both fixed rate and variable rate debt to
finance its operations. As of September 30, 2001, the Company's total
outstanding loans and debentures payable of $22,318,000 (excluding debt
associated with the discontinued hotel operations) were comprised of
$10,468,000 of fixed rate debt and $11,850,000 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 $223,000, assuming that outstanding debt
remained at current levels.
The Company's real estate division through its investment in HRP will
sometimes use derivative financial instruments to achieve a desired mix of
fixed versus floating rate debt. As of September 30, 2001, 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.
Page 31
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
PART II - OTHER INFORMATION
<Table>
<Caption>
Item
1 Legal Proceedings
Reference is made to Note 10 to the Company's consolidated financial
statements included within this Form 10-Q.
2 Changes in Securities
Reference is made to Note 4 to the Company's consolidated financial
statements included within this Form 10-Q, wherein bondholders for the 10%
Debentures have granted a waiver to a previously reported technical default.
3 Defaults upon Senior Securities
Certain of the Company's hotel subsidiaries are in default on term loans
associated with the respective hotel properties and foreclosure
proceedings have been initiated by the lenders.
4 Submission of Matters to a Vote of Security Holders
None
5 Other Information
None
6 Exhibits and Reports on Form 8-K
None
</Table>
Page 32
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
THE HALLWOOD GROUP INCORPORATED
Dated: November 14, 2001 By: /s/ Melvin J. Melle
-------------------------------
Melvin J. Melle, Vice President
(Duly Authorized Officer and
Principal Financial and
Accounting Officer)
Page 33
THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES
INDEX TO EXHIBITS
<Table>
<Caption>
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
NONE
</Table>
Page 34