HALLWOOD GROUP INC HWG
November 28, 2010 - 3:52pm EST by
RoboCop
2010 2011
Price: 21.33 EPS $0.00 $0.00
Shares Out. (in M): 2 P/E 0.0x 0.0x
Market Cap (in $M): 33 P/FCF 0.0x 0.0x
Net Debt (in $M): 13 EBIT 0 0
TEV ($): 17 TEV/EBIT 0.0x 0.0x

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Description

The Hallwood Group (HWG) is a low-liquidity microcap company likely facing meaningfully lower future revenues, and when coupled with its high operating leverage, should see significantly lower future earnings. The CEO is highly paid, owns 66% of the shares, has a history of related party transactions with the company, and some might say is of questionable integrity. The company has both supplier and customer concentration risk, and is facing several significant lawsuits that could eliminate any equity value in the stock.  I think it is an attractive long.  

I do not have any special insight to the two major legal cases the company is involved in. As the value of HWG heavily depends on the outcome of these cases, I would recommend performing your own research about the cases before coming to an investment decision.

HWG owns a textile subsidiary that sells specialty fabric to U.S. military contractors. Sales and earnings have been very good the last couple of years in this segment, but are at risk due to declining defense spending and the possibility of losing the ability to manufacture its most profitable products as the result of a pending lawsuit. HWG is also a defendant to a $200M lawsuit regarding its involvement with a bankrupt energy partnership. While HWG certainly has some significant issues, I think the price makes up for the risks. Trading at less than 2xTTM EPS and .5x TBV, shares of HWG offer significant potential for appreciation.

Overview and History

The Hallwood Group is a holding company formed in 1981 that has historically been involved in various real estate portfolios, energy partnerships, textile companies, and hotel and restaurants chains. Hallwood is only involved in the textile business today, operating within its Brookwood subsidiary.

In 2004 and 2005, Hallwood sold its real estate partnership for $66M and its previous energy ventures for $110M. HWG then paid $66M of dividends to stockholders ($43.87/sh), using the rest of the funds primarily for capital contributions to Hallwood Energy L.P. (H.E.), another private energy partnership focusing on natural gas exploration. In December of 2008, an additional $12M ($7.89/sh) dividend was distributed to HWG stockholders.

Hallwood Energy filed Chapter 11 bankruptcy in March of 2009, with HWG losing its entire ~$75M contribution ($61.3M equity, $14.3 in convertible debt). HWG owned half of the general partner and 22% of the limited partner interests at the time of the filing. The H.E. investment was previously reported under the equity method of accounting, with HWG recognizing its proportionate share of H.E.'s net loss. The bankruptcy could have been a positive development, with HWG no longer contributing capital to the partnership and no longer reported its share of H.E.'s losses, allowing the consolidated company to show the true profitability of the textile operations. But after the bankruptcy filing, FIE Shale, an investor in the partnership, filed a $200M punitive lawsuit against the Hallwood Group with the potential to wipe out the equity holders of the stock. While this is a significant risk which I will discuss later, I think the probability of a payout of that magnitude is very low.

While not always the best indicator, management does not seem overly worried about either of the lawsuits, with SEC filings mentioning that they does not expect any of the lawsuits to have a material adverse effect on the company. The company even decided to exercise the purchase option of its leased Brookwood Laminating Connecticut production facility for $3.2M in 2Q2010, perhaps showing some confidence in the outcome of the Nextec lawsuit.

CEO/Related Party Transactions

Anthony Gumbiner is the CEO, chairman, and 66% owner of the company. He is 65 and has served as a director and Chairman of the Board since 1981, and CEO since 1984. He is also the manager/owner of Hallwood Investments Limited (HIL), and is paid $.9M/yr through HIL for "consulting" fees regarding strategic planning and merger activities. This is effectively his CEO compensation. He is also paid $.6M/yr for office space rental fees and travel expenses through HIL. He received $9.9M in bonuses after the sale of the real estate and previous energy assets in 2004 and 2005.

In June of 2007, Gumbiner proposed to the board that the company be liquidated. The stock was trading around $85 at the time. Gumbiner's proposal included him negotiating to buy HWG's stake in Hallwood energy while selling Brookwood for cash to a third party, with the cash proceeds generated from the sales distributed shareholders. In November of 2007, Gumbiner withdrew his proposal, because his offer "to purchase the Company's interest in Hallwood Energy could conflict with Hallwood Energy's effort to obtain additional capital."  In April of 2009, when the stock was trading around $10, Gumbiner, operating through his vehicle Hallwood Financial Limited, offered to buy the remaining 34% of HWG shares that it didn't own for $12 in cash. The offer was turned down by the board in June of 2009 after the stock price rose over $14.

I think there is a fairly strong possibility that Gumbiner puts Brookwood up for sale after the resolution of the lawsuits. If Brookwood is sold, 15% of the fair market value above $14M will go to employees participating in Brookwood's 2005 Long-Term Incentive Plan. If certain Brookwood senior executives have an interest of less than 2% of the company purchasing Brookwood, then the minimum amount to be issued under the plan is $4.6M.  

Brookwood

Brookwood is a nylon textile converting and finishing company that was bought out of bankruptcy in 1988. It's no secret that textile manufacturing is an industry with terrible economics.  Manufacturing a commodity product with severe cost disadvantages (to foreign competitors with low-cost labor) usually does not result in high returns. This was the case for Brookwood throughout the 1990's, with revenues muddling along the $70M range, operating margins around 1.2%, and pretax ROA around 2.4%.

In 2000 Brookwood formed a 50/50 JV, Strategic Technical Alliance (STA), with an unrelated company, fully acquiring STA in September of 2002. In January of 2003, Brookwood was granted a patent for a breathable waterproof laminate process (expiring in 2019), used in the production of specialty fabric for U.S. military contractors. The significant increase in demand as a result of increased U.S. military activity, along with differentiation and pricing power provided by the patent and the Berry Amendment, caused the economics of Brookwood's textile operations to dramatically improve. 

As can be seen in the figures below, Brookwood's sales' and profitability substantially improved over the last decade: 


2002

2003

2004

2005

2006

2007

2008

2009

Sales

85.9

104.7

136.3

133.1

112.2

132.5

162.2

179.6

Operating Income

2.7

6.0

18.5

11.7

5.6

12.5

21.3

32.3

Operating Margin

3.1%

5.8%

13.5%

8.8%

5.0%

9.4%

13.1%

18.0%

Pretax ROA

5.9%

11.9%

30.5%

24.1%

10.7%

18.8%

35.3%

40.4%

 

The improvement wasn't continuous however, with sales and operating income decreasing in 2005 and 2006 before ramping up again in 2007-2009. Hallwood contributed the sales fluctuations to the military limiting order size, adopting continually revised specifications for new products, and releasing contracts for shorter periods than in the past. The company has continually stated its inability to predict future sales trends.

After three quarters of revenues and operating earnings at or near record highs for the company, Brookwood's 3Q10 sales and operating income dropped by 23% and 39% from 2Q10. The change in HWG's net income was even more dramatic because of the operating leverage caused by HWG's corporate expenses. HWG's net income decreased from $4.8M in 2Q10 to $.4M in 3Q10. In addition to the decrease in Brookwood sales, net income was affected by considerably higher HWG corporate expenses, due to increased legal fees.

With the companies' long history of legal entanglements; I would be weary of someone telling me that 3Q10's corporate SGA was higher because of "one-time" legal expenses. But it is. In August the company's insurance carrier decided to deny legal fee reimbursement in reliance on the "insured vs. insured" exclusion in the policy (from the Hallwood Energy lawsuit). The Company demonstrated that the exclusion does not apply and in November 2010, the insurance carrier informally agreed to pay the previously unreimbursed defense costs of the Company. This means HWG should be getting around $1.2M of litigation expenses incurred in 3Q10 reimbursed in 4Q10. I estimate run rate corporate SGA expenses to be ~$5-6M going forward. 

While Brookwood's recent history has looked very good, it future looks decidedly less bright. With combat operations ending in Iraq and the planned drawdown of 150,000 American troops in Afghanistan over the next four years, demand for Brookwood's camouflage-printed waterproof nylon outwear going forward will not be as high as 2009 and 2010H1. Brookwood has noted that some of its suppliers are entering the military markets in competition to Brookwood, targeting specific military specifications.  Reduced demand and increased competition should work to decrease future sales and margins. In addition a patent lawsuit threatens the future of Brookwood. An unfavorable ruling in the Nextec case would likely eliminate the vast majority of military sales.

Nextec Lawsuit

In July 2007, Nextec Applications, Inc. filed a lawsuit claiming that Brookwood violated various Nextec patents relating to the application of materials to produce weather-resistant fabrics. There were ten individual patent claims in dispute stemming from four patents assigned to Nextec. In March 2010, the court dismissed Nextec's claims of infringement in summary judgment for seven of the ten remaining patent claims. The three remaining patents in question are one claim from the '902 patent and two claims from the '841 patent. Brookwood requested reconsideration with respect to the remaining claims, but was denied on June 8, 2010. However, the court granted Brookwood leave to renew its motion for summary judgment of patent invalidity with respect to the '902 patent, which it filed on June 28, 2010, and is currently pending. After the remaining motion for summary judgment is decided (which Brookwood will likely lose), Nextec and Brookwood may try to settle the case.

To win the '902 infringement case, Nextec bears the burden of showing, by a preponderance of the evidence, that each limitation of the patent is found in Brookwood's military Storm-Tec Products. In my opinion, this claim is the biggest risk to the stock. Brookwood's strategy to defend the case is to: (1) Assert patent invalidity for the '902 patent because a product with all the attributes of the patent (most likely Storm-Tec) existed before the patent was filed. (2) Assert patent invalidity because the '902 patent was anticipated by two previous patents, and (3) Assert that Brookwood's products do not infringe on the '902 patent.

Based on Nextec's expert testimony, it appears that the Storm-Tec products contain each limitation of the '902 patent, with some ambiguity of whether the products are created through a process called shear thinning (which it seems is a difficult task to prove). Arguing Storm-Tec products are not created through this process seems to be Brookwood's best defense against the patent.

For the patent invalidity arguments, Brookwood has the burden of proof to demonstrate that some specific article of clothing contained each and every element of the '902 patent before the patent was granted, or that one of potentially two earlier patents existed before the '902 patent was essentially the same as the '902 patent.  As courts lean towards the assumption that the patent office did its job and that existing patents are valid, I view the patent invalidity defenses of Brookwood of having a remote chance of success.

The '841 patent relates to an apparatus for controlling the placement of a curable, shear-thinnable polymer composition into a porous web. Brookwood contends that claims 1 and 57 of the '841 patent are invalid because they are anticipated by Brookwood's machine, the KK-1 coater. Brookwood argues that the KK-1 has been in use since the mid-1980 and thus invalidates the '841 patent. Nextec argues that the machine was changed in 2006 to meet revised government fabric specifications and began infringing on the '841 patent at that time. Brookwood contends that the machine has not been modified, and the determination in court of whether Brookwood modified the machine will decide whether Brookwood is in violation of the '841 patent.

Based on 2006 letters to the government, Brookwood changed something in order for its products to meet the U.S. government's Gen III contract requirements. Brookwood claims that it was a fabric issue, with Nextec claiming that it was a machine issue in order to achieve one of the process claims of the machine described in the '841 patent. The lawsuit is filed against Brookwood but not the Hallwood holding company. If Nextec is successful in demonstrating willful infringement, Nextec can seek treble damages and attorneys' fees if deemed an "exceptional case."

FEI Share Lawsuit

FEI shale and other entities (bankruptcy trustee and other creditors) filed a lawsuit against the HWG alleging actual, compensatory and exemplary damages in excess of $200M based on purported breach of contract, fraud, breach of fiduciary duties, neglect, negligence and various misleading statements, omissions, and misrepresentations.

In June 2008, Hallwood Energy entered into an agreement for the sale and farmout to FEI Shale, L.P. ("FEI"), a subsidiary of Talisman Energy, Inc. The agreement entailed FEI paying up to $125M of funding to Hallwood Energy (an initial payment of $60M and the option to pay up to an additional $65M) and providing consulting services in exchange for a 33% interest in Hallwood Energy.   The agreement also included an Equity Support Agreement, where Hallwood was required to contribute $12.5M in additional debt and equity under certain conditions.

HWG contributed $5M around the closing of the FEI transaction, and loaned an additional $4.3M in September of 2008. In October of 2008, FEI elected to make a second funding payment of $30M to Hallwood Energy. In February 2009, FEI elected to make a funding in the amount of $15M related to its third payment. After the $15M funding, FEI demanded that HWG contribute the remaining $3.2M required under the Equity Support Agreement. HWG refused, saying that it considered the farmout and equity support agreement to be terminated because of the Hallwood Energy's insolvency. In March, 2008 Hallwood Energy filed for bankruptcy, with the lawsuits soon following.

FEI is and the trustee are claiming that HWG's failure to pay the $3.2M violated the Equity Support Agreement, and caused damages beyond $3.2M, including $20M in funding that FEI would have provided H.E. if HWG had contributed the remaining $3.2M, as well as all the other losses associated with the bankruptcy. FEI is claiming that HWG is guilty of fraud by non-disclosure relating to HWG's failure to disclose that it considered the Equity Support Agreement terminated and was not planning on contributing the remaining $3.2M. While claiming that HWG's non contribution caused damages of $20M due to FEI not funding its third round of financing, the suit simultaneously claims that HWG's non-contribution cost FEI the $15M in third round funding that it wouldn't have made if it had known about HWG's intentions. FEI is also claiming it would have demanded repayment of part of the second round of funding that had yet to be spent upon learning of HWG's intentions.

My opinion of the case is that FIE may have legal recourse to the $3.2M contingent payment, and perhaps even repayment of the $15M third round funding if HWG is found to be in violation of the Equity Support Agreement. I think the $200M damage figure is unreasonable and that the case is much more likely decided for a max of about $20M; but the final results will of course be unpredictable. HWG's motion to compel arbitration was denied because the equity support agreement was not found to have intent to arbitrate disputes and because HWG had waived its right to arbitrate through participating in prior court proceedings. The trial is to occur for three days in November 2010 and four days in December 2010, to the extent those dates are necessary.

Valuation

Below is a financial history of Brookwood/Hallwood and a projection of financial results under two different scenarios:

     

Brookwood/Hallwood Financial History

3Q Run Rate Adj. for Corp SGA

Military Sales 1/2 of 3Q10 Run Rate


2007

2008

2009

1Q10

2Q10

3Q10

YTD 3Q10

Military Sales

70.0

101.8

130.1

34.7

35.3

23.3

93.2

93.0

40.0

Non Military Sales

62.5

60.4

49.5

12.5

12.6

13.5

38.6

54.1

50.0

Total Sales

132.5

162.2

179.6

47.2

47.9

36.8

131.8

147.1

90.0

COGS

104.9

123.8

128.8

32.7

34.2

28.5

95.3

113.8

73.0

Gross Margin

27.6

38.4

50.7

14.5

13.7

8.3

36.5

33.3

17.0

Gross Margin %

20.8%

23.7%

28.3%

30.7%

28.7%

22.6%

27.7%

22.6%

18.9%

SGA Expenses

15.1

17.1

18.4

4.5

4.8

4.3

13.5

17.0

10.80

% of Sales

11.4%

10.6%

10.3%

9.4%

9.9%

11.6%

10.2%

11.6%

12.0%

Brookwood Op. Income

12.49

21.30

32.32

10.03

8.98

4.06

23.07

16.26

6.20

Brookwood Op. Margin

9.4%

13.1%

18.0%

21.3%

18.7%

11.1%

17.5%

11.1%

6.9%

Corporate SGA

5.21

5.53

6.69

1.85

1.40

3.11

6.35

6.00

6.00

Hallwood Op. Income

7.27

15.77

25.63

8.18

7.58

0.96

16.71

10.26

0.20

 

The first scenario annualizes Hallwood's 3Q10 operating income, adjusting downward the legal expenses. While corporate SGA may be slightly higher than $6M for the next year or two during the lawsuits, I think it is a reasonable to use for future projections. This shows that even after the decline of business in the recent quarter, HWG is still priced extremely cheap in relation to its current results.

It is probable that the first scenario still overstates the earning power of Brookwood, as further military declines are likely. The second scenario projects Hallwood's operating income with a further 57% decline in military sales and an 8% decline in non-military sales. Gross margin is calculated using a 14% estimate for non-military sales, equal with historic pre-2003 margins, and a 25% margin on military sales, down from recent ~34% margins. This scenario shows that if Brookwood is able to reduce its corporate expenses in line with the lower revenues, which I think is reasonable after a couple quarters of adjustment, Hallwood will operate at about breakeven. In the event of an unfavorable Nextec lawsuit ruling, Brookwood will probably operate at about breakeven at the subsidiary level.

It's also possible that the recent decline in military sales was largely the result timing issues for military orders. Profitability could return back to 2008/2009 levels, and if the Nextec lawsuit is ruled favorably, investors may be willing to put a high multiple on earnings, resulting in a large jump in the stock price. Military demand also has the possibility of increasing as the result of new conflicts.

It's important to remember that Hallwood is separated from Brookwood at the holding company level. It is not required to contribute more capital to Brookwood to cover operating losses, lawsuit judgments, or Brookwood debt. Brookwood can only detract from HWG's value to the extent that its operating income no longer covers HWG's corporate SGA or Hallwood decides to contribute capital to cover operating losses. This limits the downside somewhat from unfavorable Nextec lawsuit developments. If Nextec wins the patent case but cannot demonstrate "willful infringement", Brookwood is probably worth its liquidation value.

HWG is currently priced at about liquidation value, as shown below:

Liquidation Value Analysis

Value in $M

Liquidation Adjustment

Estimated Liq. Value in $M

Cash

16.3

100%

16.3

Accounts Receivable

28.4

85%

24.1

Inventories

21.0

60%

12.6

Land and Buildings

10.5

50%

5.3

Machinery and Equip.

9.8

0%

-

Other

2.8

0%

-

Total Assets

88.7


58.3





Accounts Rec and Accrued Expenses

15.1

100%

15.1

Income Tax Payable

1.4

100%

1.4

Debt - WC Revolver - Due 2014

3.0

100%

3.0

Contingent Investment in Hallwood Energy

3.2

100%

3.2

Estimated Liquidation Expenses and Other

3.0

100%

3.0

Total Liabilities

25.7


25.7





Net

63.0


32.6

Diluted Shares Outstanding

1.53


1.53

Per Share

41.34


21.38

Due to the Hallwood Energy lawsuit, liquidation value is not the downside in this case. A summary judgment for the full $200M would likely mean a total loss to your investment. With that in mind, let's look at some possible valuation scenarios for HWG.

Current Price

          21.33


Assumes no additional fine in Hallwood Energy case

Scenario

Large loss in Hall-wood Energy Case

Hallwood Energy Case Settled for $20M

Declining business/ Nextec lawsuit fines make Brookwood worthless

No fine in H.E. case/ Liquidation of HWG

Military Sales 1/2 from 3Q10 level

3Q10 Run Rate Adj for Lower Corp. SGA

Brookwood at 2008 sales and profit levels

3Q10 Cash


16.3

10.5

16.3

16.3

16.3

16.3

+ Cash From WC Release


12.7

(3.8)

22.5

12.7


(8.8)

Less Debt


3.0


3.0

3.0

3.0

3.0

Net Cash

-

26.0

6.7

35.8

26.0

13.3

4.5

Brookwood Value

-

30.0

-

-

30.0

50.0

92.0

Brookwood Valuation Assumption

Value Less than H.E. lawsuit

Annual Sales fall to $90M - Sale of Brookwood at ~4.87x Operating Income/ 1/3 of sales

Only included estimated Holdco cash and debt. WC release includes est. for paying Holdco liabilities.

Liquidation Value. WC release includes discharge of other liabilities and liq. Expenses

Annual Sales fall to $90M - Sale of Brookwood at ~4.87x Operating Income/ 1/3 of sales

7.5x HWG Net Income. ~12% discount rate and -1% growth

Military sales decline was just timing issue. 9x 2008 Level HWG Net Income.

Asset Value

-

56.0

6.7

35.8

56.0

63.3

96.5

Less H.E. Contingent Payment


3.2

3.2

3.2

3.2

3.2

3.2

Less H.E. Judgment

200.0

20.0






Less 2005 LT Brookwood Incentive Plan


4.6



4.6



Net Value

(200.0)

28.2

3.5

32.6

48.2

60.1

93.3

Per Share

-

18.49

2.30

21.38

31.60

39.41

61.17

Gain

-100%

-13%

-89%

0%

48%

85%

187%

Working capital is estimated to stay at around 24% of sales for Brookwood, a figure which has been fairly steady. Depreciation expense should be similar to capital expenditures going forward, allowing net income to be a close proxy for free cash flow.

Conclusion

My probability weighted estimate of the value of HWG is around a 50% gain from the current stock price ($~32 target), with the most likely scenario around the same price, the result of a small fine from the H.E. energy suit and substantial declines in military sales as a result of some combination of decreasing demand and the Nextec lawsuit. While HWG certainly has plenty of risk, I think that it also offers investors good prospects for returns at the current price.

 

 

 

 

Catalyst

 Hallwood Energy lawsuit developments - December/January 2010
 10K/Earnings release - April 2011
 Nextec patent lawsuit developments - TBD
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