The Hallwood Group (HWG) – A Tale of Legal Woes

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The Hallwood Group (HWG) is a holding company that owns a specialty textile manufacturer, Brookwood Companies. HWG also held a stake in an oil and gas partnership, Hallwood Energy, that went bankrupt in 2009. HWG has been dealing with a host of litigation relating both to liabilities stemming from the bankruptcy as well as alleged patent infringement in the textile business. And while Brookwood had a run of substantial profitability from 2008 to 2010, the business tanked in 2011. Is there value in HWG hiding behind their legal problems?

The Legal Issues

First, the legal issues. HWG had an Equity Support agreement with Hallwood Energy to invest $12.5 million in Energy. HWG refused to fund the last $3.2 million, claiming there were grounds to terminate the support agreement.  Hallwood Energy and its outside investors brought an adversary proceeding against HWG, claiming that HWG violated the agreement and caused the bankruptcy of Hallwood Energy. In July 2011 the Bankruptcy Court issued proposed findings of a judgement against HWG for $18.7 million plus pre and post judgement interest and attorney’s fees. The District Court will issue the final ruling in the case, and could change the judgement in either direction. It is unknown when the District Court will rule.

A second suit stemming from the Hallwood Energy bankruptcy was brought by Hall Phoenix, who were investors in Hallwood Energy. They claimed they were defrauded by HWG regarding the nature of the investment in Hallwood Energy. This suit was settled in February 2012 for $1.8 million and HWG has paid the settlement.

Finally, HWG is also dealing with a suit for patent infringement brought against Brookwood surrounding patents related to military fabrics. Nextec Applications initially filed the suit in 2007, and at one point there were ten patents involved. Brookwood has managed to get the claims regarding eight of the patents thrown out, leaving only two in the case. However, Brookwood filed for those two patents to be reexamined by the US Patent Office. The Patent Office has issued first office actions rejecting the two Nextec patents as unpatentable due to prior art, though Nextex can respond to this action. The trial on this issue is scheduled to begin on April 30th.

The Business

Brookwood converts, finishes, and laminates woven synthetics with plants in Rhode Island and Connecticut. They specialize in producing nylon camouflage fabrics for clothing suppliers to the military. Brookwood entered into the specialty military fabric business in 2000 when they set up a joint venture with Strategic Tactical Alliance, and then proceeded to buy out STA’s stake in the JV in 2002.

Brookwood’s financial results have been volatile over the years, as can be seen in the summary below:

They depend in part on the timing of large military purchases, which are very cyclical and unpredictable. 08-10 were very strong years, but sales to military contractors declined $40.4 million in 2011 and EBIT declined from $24.6 million to $5.5 million. SG&A expense over the past few years is probably $1-2 million higher than a normalized number due to legal expense relating to the NexTec lawsuit.

Expense on the HWG level was $5.3 million in 2011, which is about average for the company. The HoldCo expense has fluctuated due to legal fees, so I have put in the $5.3  million as a normalized number in the table above to calculate EBIT on the HWG level.

Valuation

On an asset basis, HWG certainly looks cheap even if we take a mid-range scenario for the legal outcomes. As of December 31, HWG had reserved $12.5 million for the adversary proceeding and Hall lawsuit. If we assume a $20 million total judgement for the adversary proceeding and the $1.8 million Hall settlement that would add $9.3 million in liabilities to the balance sheet. That gets us to the following book, net working capital, and liquidation values for HWG:

(Liquidation assumes cash valued at 100%, A/R at 90%, inventory at 50%, and PP&E at 35%). Those numbers compare to a current share price of $9.75. So the market is valuing HWG at liquidation value even after accounting for a reasonable legal liability scenario.

There are three unknowns that make it difficult to value HWG: the outcome of the adversary proceeding, the outcome of the patent lawsuit, and the wildly fluctuating results of the Brookwood business.

At least for the adversary proceeding we have the proposed findings of the Bankruptcy Court, although they could be changed by the District Court. If it does come in around $20 million then HWG certainly has the asset value to handle it, although liquidity could be an issue. HWG received a going concern qualification on their 10K due to the adversary proceeding judgement and insufficient cash on the balance sheet to pay it off. HWG had $10.9 million in consolidated cash, but only $6.7 million on the HoldCo level (and only $4.9 million after paying the Hall settlement). Due to an agreement with their lenders, Brookwood can only dividend 50% of their net income up to HWG. Brookwood would have to get a release to from their lenders to send more cash to HWG, which might be an impediment to paying off the judgment, although HWG has other options (take on debt at the HoldCo level or sell some or all of the company’s assets).

The outcome of the patent case might be the biggest risk as it could potentially impair much of the value in the textile business if Brookwood loses. Brookwood appears to be winning the case to date, but that is out of my circle of competence to analyze.  And aside from the patent case, it is unclear what the Brookwood business is worth given the very cyclical results and dependence on the military.

If the textile business were more stable it is possible that the risk/reward in HWG at these price levels might be compelling even with the patent risk. But without being able to come an informed opinion about the patent case I think it is hard to invest in HWG with the unclear upside in the Brookwood business and the potential downside in both the patent case and the adversary proceeding.

Disclosure: No position.

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10 Responses to The Hallwood Group (HWG) – A Tale of Legal Woes
  1. matt
    April 27, 2012 | 10:24 pm

    Hi Elie – I haven’t looked at this for a year or so, but it seems not much has changed. The main reason I didn’t invest a year ago (when on balance, things probably looked a little better) was MANAGEMENT. From my review at the time, I thought the CEO (admittedly a major shareholder) treats this company as his own. At one point the company was going to set up an investment fund to invest the cash balances (even with the lawsuits), but I think they got some pushback on that idea. I would be interested if you were able to contact management and gain any comfort they would act in ALL shareholders’ interests.

    Reply
    • Elie Rosenberg
      April 29, 2012 | 2:55 pm

      I haven’t talked to management. I agree management deserves some scrutiny here. The CEO who is the majority owner of the equity takes out about $1.5 million a year all in, which is excessive but par for the course in these insider controlled companies. And capital allocation has also obviously been questionable (although they have no excess capital so that isn’t an issue for the time being). But with the stock trading at a fraction of book value I don’t think management is the major risk. It seems like basically if the company can get through all these legal issues and remain a going concern with a viable textile business then the stock is worth more than the current quote. If the stock was trading at $20+ and the market was assigning some value to the operations then I think questionable management would be more of an issue.

      Reply
  2. Tom L
    April 29, 2012 | 11:30 am

    Love the blog.

    I looked at HWG a few years ago, and I didn’t trust management. I seem to remember a long history of legal issues. Do you trust management to do the right thing for shareholders?

    Keep up the good work.

    Cheers,
    Tom L

    Reply
    • Elie Rosenberg
      April 29, 2012 | 2:58 pm

      Thanks for the kind words.

      See my comment above. At the current price per share I don’t think management is one of the major risks, but I agree they don’t have a great track record. I still am not comfortable with the stock for now given both the legal and operational risks.

      Reply
  3. Baruch
    April 30, 2012 | 2:29 pm

    I guess this is as good a time as any to ask the exceptional valueslant community about evaluating management. Time and again, Buffet emphasizes the importance of able and honest management, but we are left to wonder how is one to go about discerning between the good, the bad, and the ugly. Obviously we can get a superficial glimpse of at least what they preach, but public announcements and letters are hardly a reliable source upon which to base crucial judgement. To rate MGMT based on performance would be redundant to assessing the quality of the business. Any ideas?

    Reply
    • Elie Rosenberg
      May 2, 2012 | 8:32 am

      I agree- I think it is hard for outside minority investors to get a good sense of management quality except in hindsight, at which point the good/bad results are usually already priced into the stock.

      Reply
  4. Steven
    May 23, 2012 | 10:24 pm

    What are your thoughts now that the court has issued a final judgment?

    Reply
    • Elie Rosenberg
      May 29, 2012 | 6:03 pm

      I think they came out pretty well in that regard. I am still worried about the patent issue. Looks like the trial is going on now.

      Reply
  5. Saquib Toor
    May 29, 2012 | 11:15 pm

    Great blog and I am glad i came across it. I spoke to mgmt a few weeks ago. I will reserve my opinion of mgmt but they seemed to indicate that if they lost the patent case the patents relate to a small part of the textile business revenues.

    Reply
    • Elie Rosenberg
      May 30, 2012 | 10:04 am

      Thanks…that is very interesting.

      Reply
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