SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

MARK ONE

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     

For the Period Ended June 30, 2005                    Commission File Number: 1-8303

The Hallwood Group Incorporated

(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		51-0261339 (I.R.S. Employer 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

		Name of Each Exchange
Title of Class		On Which Registered
Common Stock ($0.10 par value)		American Stock Exchange

Series B Redeemable Preferred Stock

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES þ NO o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12B-2 of the Act).

YES o NO þ

     1,511,218 shares of Common Stock, $.10 par value per share, were outstanding at July 31, 2005.

 

 

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

TABLE OF CONTENTS

ITEM NO.						PAGE
				PART I — FINANCIAL INFORMATION
	1			Financial Statements (Unaudited):
				Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004			3
				Condensed Consolidated Statements of Operations for the Six Months Ended June 30, 2005 and 2004			4
				Condensed Consolidated Statements of Operations for the Three Months Ended June 30, 2005 and 2004			5
				Condensed Consolidated Statements of Comprehensive Income for the Three Months and Six Months Ended June 30, 2005 and 2004			6
				Condensed Consolidated Statement of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2005			7
				Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004			8
				Notes to Condensed Consolidated Financial Statements			9
	2			Management’s Discussion and Analysis of Financial Condition and Results of Operations			25
	3			Quantitative and Qualitative Disclosures about Market Risk			36
	4			Controls and Procedures			37
				PART II — OTHER INFORMATION
1 thru 6				Other Information			38
				Signature Page			39
				Index to Exhibits			40
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification Pursuant to Section 906

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
(unaudited)

		June 30,				December 31,
		2005				2004
ASSETS
Current Assets
Cash and cash equivalents		$	20,598			$	71,549
Marketable securities — trading			202				6,100
Accounts receivable
Trade and other			25,380				25,340
Related parties			218				165
Inventories			17,067				23,581
Prepaids, deposits and other assets			1,761				1,314
Deferred income tax			1,393				2,213
Restricted cash — related parties			—				218
			66,619				130,480
Noncurrent Assets
Investments in energy affiliates			18,354				12,491
Property, plant and equipment, net			11,000				11,070
Deferred income tax			3,025				2,444
Other assets			277				503
			32,656				26,508
Discontinued Operations
Real estate			43				329
Total Assets		$	99,318			$	157,317
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable		$	8,314			$	15,095
Related party payables			5,000				490
Accrued expenses and other current liabilities			4,671				5,722
Current portion of loans payable			344				347
Income taxes payable			—				1,167
			18,329				22,821
Noncurrent Liabilities
Long term portion of loans payable			11,790				8,789
Redeemable preferred stock			1,000				1,000
			12,790				9,789
Discontinued Operations
Real estate			—				166
Total Liabilities			31,119				32,776
Stockholders’ Equity
Common stock, issued 2,396,103 shares at both dates; outstanding 1,511,218 and 1,326,343 shares, respectively			240				240
Additional paid-in capital			56,443				54,792
Retained earnings			24,697				85,443
Treasury stock, 884,885 and 1,069,760 shares, respectively; at cost			(13,181	)			(15,934	)
Total Stockholders’ Equity			68,199				124,541
Total Liabilities and Stockholders’ Equity		$	99,318			$	157,317

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

		Six Months Ended
		June 30,
		2005				2004
Revenues
Textile products sales		$	71,684			$	66,794
Administrative fees from energy affiliates			1,499				—
			73,183				66,794
Expenses
Textile products cost of sales			56,502				50,064
Administrative and selling expenses			18,841				8,366
			75,343				58,430
Operating income (loss)			(2,160	)			8,364
Other Income (Loss)
Interest and other income			848				3
Equity income from investments in energy affiliates			194				520
Interest expense			(302	)			(780	)
Adjustment to gain from disposition of HEC			(113	)			—
Amortization of deferred revenue — noncompetition agreement			—				1,007
Separation Agreement income			—				375
			627				1,125
Income (loss) from continuing operations before income tax expense (benefit)			(1,533	)			9,489
Income tax expense (benefit)			1,878				(6,489	)
Income (loss) from continuing operations			(3,411	)			15,978
Income (loss) from discontinued operations, net of tax
Real estate			—				11,667
Hotels			—				(299	)
			—				11,368
Net Income (Loss)		$	(3,411	)		$	27,346
Per Common Share
Basic
Income (loss) from continuing operations		$	(2.47	)		$	12.05
Income from discontinued operations			—				8.57
Net income (loss)		$	(2.47	)		$	20.62
Assuming dilution
Income (loss) from continuing operations		$	(2.47	)		$	10.97
Income from discontinued operations			—				7.80
Net income (loss)		$	(2.47	)		$	18.77
Weighted Average Shares Outstanding
Basic			1,379				1,326
Assuming dilution			1,379				1,457

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

		Three Months Ended
		June 30,
		2005				2004
Revenues
Textile products sales		$	35,289			$	35,554
Administrative fees from energy affiliates			568				—
			35,857				35,554
Expenses
Textile products cost of sales			27,822				25,841
Administrative and selling expenses			12,011				4,139
			39,833				29,980
Operating income (loss)			(3,976	)			5,574
Other Income (Loss)
Equity income from investments in energy affiliates			500				439
Interest and other income			200				1
Interest expense			(168	)			(391	)
Amortization of deferred revenue — noncompetition agreement			—				403
Separation Agreement income			—				375
			532				827
Income (loss) from continuing operations before income tax expense (benefit)			(3,444	)			6,401
Income tax expense (benefit)			873				(4,259	)
Income (loss) from continuing operations			(4,317	)			10,660
Income (loss) from discontinued operations, net of tax
Real estate			—				3,142
Hotels			—				(175	)
			—				2,967
Net Income (Loss)		$	(4,317	)		$	13,627
Per Common Share
Basic
Income (loss) from continuing operations		$	(3.02	)		$	8.04
Income from discontinued operations			—				2.23
Net income (loss)		$	(3.02	)		$	10.27
Assuming dilution
Income (loss) from continuing operations		$	(3.02	)		$	7.27
Income from discontinued operations			—				2.03
Net income (loss)		$	(3.02	)		$	9.30
Weighted Average Shares Outstanding
Basic			1,431				1,326
Assuming dilution			1,431				1,466

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Net Income (Loss)		$	(4,317	)		$	13,627			$	(3,411	)		$	27,346
Other Comprehensive Income (Loss)
Pro rata share of other comprehensive income (loss) from equity investments
Amortization of interest rate swap			—				(15	)			—				(30	)
Comprehensive Income (Loss)		$	(4,317	)		$	13,612			$	(3,411	)		$	27,316

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
(in thousands)
(unaudited)

										Additional																Total
		Common Stock								Paid-In				Retained				Treasury Stock								Stockholders’
		Shares				Par Value				Capital				Earnings				Shares				Cost				Equity
Balance, January 1, 2005			2,396			$	240			$	54,792			$	85,443				1,070			$	(15,934	)		$	124,541
Net loss															(3,411	)											(3,411	)
Cash dividend on common stock															(56,789	)											(56,789	)
Reissuance of treasury shares resulting from exercise of stock options and related income tax effect			—				—				1,651				(546	)			(185	)			2,753				3,858
Balance, June 30, 2005			2,396			$	240			$	56,443			$	24,697				885			$	(13,181	)		$	68,199

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

		Six Months Ended
		June 30,
		2005				2004
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)		$	(3,411	)		$	27,346
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Decrease in inventories			6,514				84
Proceeds from sale of marketable securities			5,836				—
Increase (decrease) in accrued expenses and other current liabilities			(567	)			2,038
Increase (decrease) in accounts payable and related party payables			(1,197	)			256
Depreciation and amortization			934				883
Net change in other assets and liabilities			(1,048	)			(143	)
Deferred tax expense (benefit)			239				(7,891	)
Equity income from investments in energy affiliates			(194	)			(520	)
Adjustment to gain from disposition of HEC			113				—
Increase in accounts receivable			(93	)			(3,902	)
Loss from investments in marketable securities			62				—
Payment to exercise option of Separation Agreement			—				(3,000	)
Payment of litigation judgment to HRP			—				(1,876	)
Amortization of deferred revenue — noncompetition agreement			—				(1,007	)
Gain from extinguishment of Separation Agreement			—				(375	)
Amortization of deferred gain from debenture exchange			—				(31	)
Discontinued operations:
Net change in other assets and liabilities			120				(299	)
Equity loss from investments in HRP			—				(178	)
Deferred tax benefit			—				(9,642	)
Increase in accrued litigation expense to HRP			—				49
Net cash provided by operating activities			7,308				1,792
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in energy affiliates			(5,669	)			(1,696	)
Investments in property, plant and equipment, net			(1,452	)			(1,195	)
Proceeds from sale of investment in HEC			387				—
Discontinued operations:
Proceeds from sale of investments in HRP			59				—
Investments in hotels			—				(64	)
Net cash (used in) investing activities			(6,675	)			(2,955	)
CASH FLOWS FROM FINANCING ACTIVITIES
Cash dividend on common stock			(56,789	)			—
Proceeds from exercise of stock options			2,207				—
Proceeds (repayment) from of borrowings on revolving credit facilities, net			3,175				(3,930	)
Proceeds from other bank borrowings and loans payable			—				4,986
Repayment of other bank borrowings and loans payable			(177	)			(1,213	)
Net cash (used in) financing activities			(51,584	)			(157	)
DECREASE IN CASH AND CASH EQUIVALENTS			(50,951	)			(1,320	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD			71,549				2,885
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	20,598			$	1,565

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 1 — Interim Condensed Consolidated Financial Statements, Accounting Policies and New Accounting Pronouncements

     Interim Condensed Consolidated Financial Statements. The interim condensed consolidated financial statements of The Hallwood Group Incorporated and its subsidiaries (the “Company”) (AMEX: HWG) have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America. Although condensed, in the opinion of management, all adjustments considered necessary for a fair presentation have been included. These condensed financial statements should be read in conjunction with the audited consolidated financial statements and related disclosures thereto included in Form 10-K for the year ended December 31, 2004.

     Continuing Operations. The Company is a holding company that currently operates in the textile products and the energy business segments.

     Textile products operations are conducted through the Company’s wholly owned Brookwood Companies Incorporated subsidiary (“Brookwood”). Brookwood is an integrated textile firm that develops and produces innovative fabrics and related products through specialized finishing, treating and coating processes. Brookwood’s subsidiary, Strategic Technical Alliance, LLC (“STA”) markets advanced breathable, waterproof laminate fabrics primarily for military applications. Continued development of these fabrics for military, industrial and consumer applications is a key element of Brookwood’s business plan.

     Since January 2002, the Company has invested approximately $22,180,000 in private energy affiliates. Following the sale of Hallwood Energy Corporation (“HEC”) in December 2004 Hallwood Energy III, L.P. (“HE III”) and HE III in July 2005, the principal affiliates are Hallwood Energy II, L.P. (“HE II”) and Hallwood Exploration, L.P. (“Hallwood Exploration”). The Company has an interest of between 20% and 28% of the entities (between 16% and 22% on a fully diluted basis) and accounts for the investments using the equity method of accounting. These private energy companies are or have been principally involved in drilling of wells in the Barnett Shale formation of Johnson County, Texas and surrounding counties and conducting a 3-D seismic survey over optioned land in South Louisiana to determine if further oil and gas exploratory activity is warranted. Certain of the Company’s officers and directors are investors in and hold profit interests in the energy affiliates.

     Discontinued Operations. The Company’s real estate activities were conducted primarily through the Company’s wholly owned subsidiaries. Hallwood Realty, LLC (“Hallwood Realty”) served as the general partner of Hallwood Realty Partners, L.P. (“HRP”), a publicly traded master limited partnership. Hallwood Commercial Real Estate, LLC (“HCRE”) served as property manager. Revenues were generated from the receipt of management fees, leasing commissions and other fees from HRP and third parties and the Company’s 22% pro rata share of earnings of HRP using the equity method of accounting.

     In April 2004, HRP announced that it and certain of its affiliates had entered into an Agreement and Plan of Merger (the “Agreement and Plan of Merger”) with HRPT Properties Trust (“HRPT”), pursuant to which HRP would merge with a subsidiary of HRPT. The merger and sale were completed in July 2004. As a result, HRP became a wholly-owned subsidiary of HRPT and was no longer a publicly traded limited partnership. The general partner interest in HRP was also sold to a HRPT subsidiary in a separate transaction. The Company no longer holds any interest in HRP. The Company received $66,119,000 for its interests in HRP.

     New Accounting Pronouncements. In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payments, which establishes accounting standards for all transactions in which an entity exchanges its equity instruments for goods and services. SFAS No. 123(R) focuses primarily on accounting for transactions with employees, and carries forward without change prior guidance for share-based payments for transactions with nonemployees. There were no unvested options nor options available for grant under the 1995 Stock Option Plan, which expired on June 27, 2005. Accordingly, the Company does not expect the adoption of SFAS No. 123(R) to have any impact on its consolidated financial statements.

     Reclassifications. Following the disposition of its real estate and hotel business segments, the Company determined that its financial statements should be changed from a segmented format to a classified format; therefore, substantial reclassifications have been made to all periods presented herein.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 2—Cash and Cash Equivalents

     Cash and cash equivalents as of the balance sheet dates were as follows (in thousands):

		June 30,				December 31,
		2005				2004
Cash		$	1,102			$	457
Cash equivalents			19,496				71,092
Total		$	20,598			$	71,549

     Cash equivalents consisted of secured bank repurchase agreements, money market funds (consisting of AAA rated institutional commercial paper), government securities and interest bearing demand deposits.

Note 3—Inventories

     Inventories as of the balance sheet dates were as follows (in thousands):

		June 30,				December 31,
		2005				2004
Raw materials		$	5,513			$	8,353
Work in progress			5,371				6,883
Finished goods			7,471				9,446
			18,355				24,682
Less: Obsolescence reserve			(1,288	)			(1,101	)
Total		$	17,067			$	23,581

Note 4 — Investments in Energy Affiliates

     The Company is an investor in several energy affiliates. Provided below is information relating to each of these entities (dollar amounts in thousands):

Hallwood Energy III, L.P.

		As of June 30, 2005								Amount at								Income (loss) for the
						Cost or				which carried at								six months ended
		Number of				ascribed				June 30,				December 31,				June 30,
Description of Investment		units held				value				2005				2004				2005				2004
Hallwood Energy III, L.P.
- Limited partner interest			N/A			$	13,433			$	13,561			$	8,959			$	351			$	—

     At June 30, 2005, the Company owned approximately 28% (24% after consideration of profit interests) of HE III. It accounted for this investment using the equity method of accounting and recorded its pro rata share of HE III’s net income (loss), partner capital transactions and comprehensive income (loss) adjustments, if any.

     In 2004, the Company invested $4,705,000 in HE III, which was formed primarily to acquire and develop oil and gas lease holdings in the Barnett Shale formation of Johnson and Hill Counties, Texas. In March 2005, the Company invested an additional $4,251,000.

     In June 2004, HE III acquired from HEC approximately 15,000 acres of undeveloped leasehold, three proven developed, non-producing natural gas properties, a limited amount of gas transmission line and various other assets. As the purchase was from a related entity, for financial reporting purposes the assets were recorded at net carrying value of approximately

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

$4,400,000, of which the Company’s proportionate share was approximately $1,232,000. During July 2004, HE III entered into an agreement with Chesapeake Energy Corporation and one of its subsidiaries (“Chesapeake”), which owned approximately 12,000 net acres contiguous to that of HE III, wherein it assigned a 44% interest in its lease holdings to Chesapeake, which in turn assigned a 56% interest in its lease holdings to HE III. Under the joint operating agreement between the two entities, HE III had been designated as operator for all future development.

     HE III commenced commercial production and sales of natural gas in June 2004. In December 2004, in connection with the sale of HEC discussed below, the Company, as a shareholder in HEC, received its proportionate share of debt from HE III owed to HEC in the amount of $1,995,000, which it contributed directly to HE III as an additional capital investment. In addition, the Company received its proportionate share of HEC’s investment in its Hallwood SWD, Inc. subsidiary, with a carrying value of approximately $1,250,000, which was also contributed to HE III as an additional capital investment.

     In March 2005, an agreement was entered into with a former officer of the energy affiliates, who is not otherwise affiliated with the Company, to purchase the officer’s four percent profit interest in the energy affiliates for $4,000,000, of which $3,500,000 was ascribed to HE III and $250,000 each to HE II and Hallwood Exploration. The purchase was settled by the energy affiliates on July 1, 2005. The energy affiliates recorded the purchase amount as compensation expense in the 2005 first quarter and the Company reflected its pro rata share, approximately $1,100,000, as a reduction of the equity income from the energy affiliates.

     In June 2005, HE III obtained a revolving loan facility of $150,000,000 for Facility A and $5,000,000 for Facility B, with maturity dates of June 2007 and June 2006, respectively. The loan provided for a periodic re-determination of the borrowing base, which was initially established at $20,000,000 for both facilities. As of July 18, 2005, HE III had drawn $12,153,000 under the facility at floating interest of 5.5% for the period.

     As of July 18, 2005, HE III had drilled, acquired or was in the process of drilling 36 wells in the Barnett Shale formation in Johnson County, Texas. Twenty-four wells were producing, two wells were being drilled, eight wells were in the completion process and two wells were saltwater disposal wells. On that date, HE III held oil and gas leases covering approximately 29,000 gross and 14,000 net acres of undeveloped leasehold, predominantly in Johnson County, Texas. Natural gas production was approximately 21 million cubic feet per day, net to HE III’s interest.

     Sale of HE III. On July 18, 2005, HE III completed a merger with Chesapeake. The merger agreement provided for a total price of $246,500,000 for all of the HE III production and reserves, as well as the operational and administrative infrastructure in Johnson County, and was subject to reduction for outstanding debt, transaction costs, changes in working capital and certain other matters. After these reductions and adjustments, Chesapeake paid a total of approximately $235,000,000 at the closing, including debt owed by HE III, and management of HE III anticipates that an additional $2,500,000 will be paid upon final calculation of working capital.

     In exchange for its interest in HE III, the Company received a cash payment of $54,800,000 in July 2005 and anticipates that it will receive an additional $600,000 after calculation of HE III’s working capital is completed. The Company will report the gain from the disposition of its investment in the 2005 third quarter.

     In addition, the Company received a distribution for its proportionate share of certain pipe inventory owned by HE III, with a proportionate carrying value of approximately $1,395,000, which was contributed to HE II as an additional capital investment.

     Certain of the Company’s officers and directors are investors in HE III. In addition, individual members of management of HE III, including one director and officer and one officer of the Company, held a profit interest in HE III.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Hallwood Energy II, L.P.

		As of June 30, 2005								Amount at								Income (loss) for the
						Cost or				which carried at								six months ended
		Number of				ascribed				June 30,				December 31,				June 30,
Description of Investment		units held				value				2005				2004				2005				2004
Hallwood Energy II, L.P.
- Limited partner interest			N/A			$	3,645			$	3,561			$	2,424			$	(78	)		$	—

     At June 30, 2005, the Company owned approximately 24% (19% after consideration of profit interests) of HE II. It accounts for this investment using the equity method of accounting and records its pro rata share of HE II’s net income (loss), partner capital transactions and comprehensive income (loss) adjustments, if any.

     In September 2004, the Company invested $2,430,000 in HE II, which was formed to explore various oil and gas exploration opportunities, primarily in Texas, and in areas not associated with HEC and HE III. In June 2005, the Company invested an additional $1,215,000, and in July 2005, $1,395,000, its proportionate share of pipe inventory distributed by HE III. As of August 1, 2005, HE II holds oil and gas leases covering approximately 42,000 gross and 38,000 net acres of undeveloped leasehold in Reeves, Culberson and Hill Counties.

     Sale of Certain Assets. In connection with the July 2005 disposition of HE III, HE II sold all of its 856 net acres lease holdings in Johnson County, Texas to Chesapeake for $3,000,000. The Company will record its pro rata share of the gain from this transaction in the 2005 third quarter.

     Certain of the Company’s officers and directors are investors in HE II. In addition, individual members of management of HE II, including one director and officer and one officer of the Company, hold a profit interest in HE II.

Hallwood Exploration, L.P.

		As of June 30, 2005								Amount at								Income (loss) for the
						Cost or				which carried at								six months ended
		Number of				ascribed				June 30,				December 31,				June 30,
Description of Investment		units held				value				2005				2004				2005				2004
Hallwood Exploration, L.P.
- Limited partner interest			N/A			$	1,521			$	1,214			$	1,090			$	(79	)		$	(5	)

     At June 30, 2005, the Company owned approximately 20% (16% after consideration of profit interests) of Hallwood Exploration. It accounts for this investment using the equity method of accounting and records its pro rata share of Hallwood Exploration’s net income (loss), partner capital transactions and comprehensive income (loss) adjustments, if any.

     In 2004, the Company invested $1,318,000 in Hallwood Exploration, which was formed to develop an oil and gas opportunity in South Louisiana. In June 2005, the Company invested an additional $203,000. Hallwood Exploration has acquired seismic lease options over approximately 36,000 acres, and is currently in the process of conducting a 3-D seismic survey over the optioned land to determine if further oil and gas exploratory activity is warranted.

     Certain of the Company’s officers and directors are investors in Hallwood Exploration. In addition, individual members of management of Hallwood Exploration, including one director and officer and one officer of the Company, hold a profit interest in Hallwood Exploration.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Hallwood Energy Corporation

		As of June 30, 2005								Amount at								Income (loss) for the
						Cost or				which carried at								six months ended
		Number of				ascribed				June 30,				December 31,				June 30,
Description of Investment		shares held				value				2005				2004				2005				2004
Hallwood Energy Corporation
- Common stock			—				—				—				—				—			$	524

     The Company owned approximately 28% (22% after consideration of stock options) of HEC. It accounted for the investment using the equity method of accounting and recorded its pro rata share of HEC’s net income (loss), stockholders’ equity transactions and comprehensive income (loss) adjustments, if any.

     The Company invested $3,500,000 in HEC during 2002, $1,997,000 in 2003, and $566,000 in 2004. As of December 2004, HEC had drilled or was in the process of drilling 46 wells in the Barnett Shale formation of Johnson County, Texas. After constructing a gas gathering system, HEC commenced commercial production and sales of natural gas in February 2003.

     Sale of HEC. In December 2004, HEC completed a merger with Chesapeake, under which Chesapeake acquired HEC. In exchange for its interest in HEC, the Company received a cash payment of $53,793,000 in December 2004 and received an additional amount of $387,000 in April 2005 from the settlement of HEC’s working capital. The Company also received its proportionate share of the HE III debt in the amount of $1,995,000, which it contributed to HE III as an additional capital contribution, and its proportionate interest in Hallwood SWD, Inc., the former HEC subsidiary that owned the Worthington saltwater disposal well, with a carrying value of approximately $1,250,000, which it contributed to HE III as an additional capital contribution.

     Certain of the Company’s officers and directors were investors in HEC. In addition, individual members of management of HEC, including one director and officer and one officer of the Company, had stock options in HEC.

Hallwood Petroleum, LLC

     The Company’s Hallwood Petroleum, LLC subsidiary (“HPL”) commenced operation in October 2004 as an administrative and management company to facilitate record keeping and processing for the energy affiliates and has no financial value. All revenues are credited to, and all costs are borne by, the other energy affiliates with no profit element. All assets nominally in the name of HPL are held solely for the benefit of the other energy affiliates. HPL was formed as a subsidiary of the Company as a convenience and it was not intended that it have any financial impact on the Company. In the 2005 second quarter, the Company determined that its ownership of this pass-through entity created unnecessary complexity, therefore HPL was transferred, for nominal consideration to officers of the energy affiliates that are not officers of the Company. The transfer was completed on May 11, 2005.

Other Entities

     The Company has invested a nominal amount of funds in other affiliated entities, which principally serve as the general partners for the energy affiliates.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 5 — Loans Payable

     Loans payable at the balance sheet dates are as follows (in thousands):

		June 30,				December 31,
		2005				2004
Bank debt
Revolving credit facility, prime + .25% or Libor + 1.75% to 3.00% interest, due January 2007		$	11,152			$	7,977
Equipment term loans, 2.84% to 5.60% interest, due at various dates from October 2005 through February 2009			982				1,149
			12,134				9,126
Subordinated secured promissory note, non-interest bearing			—				10
Total			12,134				9,136
Current portion			(344	)			(347	)
Noncurrent portion		$	11,790			$	8,789

     Revolving Credit Facility. The Company’s Brookwood subsidiary has a revolving credit facility in an amount up to $22,000,000 with Key Bank National Association (“the Key Working Capital Revolving Credit Facility”). Borrowings are collateralized by accounts receivable, certain finished goods inventory, machinery and equipment and all of the issued and outstanding capital stock of Brookwood and its subsidiaries.

     The Key Working Capital Revolving Credit Facility has a maturity date of January 2, 2007, bears interest at Brookwood’s option of prime plus 0.25% or Libor plus 1.75% to 3.00% (variable depending on compliance ratios), contains various covenants, including maintenance of certain financial ratios and restrictions on dividends and repayment of debt or cash transfers to the Company. The interest rate was 6.50% at June 30, 2005. The outstanding balance at June 30, 2005 was $11,152,000 and Brookwood had approximately $10,848,000 of unused borrowing capacity.

     Equipment Term Loans. Brookwood has an equipment credit facility in an amount up to $3,000,000 with Key Bank. This facility matures in January 2007. The outstanding balance at June 30, 2005 was $982,000, and Brookwood had $2,018,000 availability under this facility.

     Loan Covenants. As of the end of all quarters in 2004 and the first two quarters in 2005, Brookwood was in compliance with its loan covenants. The Key Working Capital Revolving Credit Facility included a total debt to tangible net worth ratio covenant and an EBITDA to total fixed charges covenant. Cash dividends and tax sharing payments to the Company are contingent upon Brookwood’s compliance with the covenants contained in the loan agreement.

     On March 25, 2005, Brookwood and Key Bank entered into a loan amendment, which eliminated the borrowing base and certain other loan requirements, including the EBITDA to fixed charges covenant. In addition, the total debt to tangible net worth ratio covenant was reduced to 1.50 from 1.75 and a new covenant was added that Brookwood shall maintain a quarterly minimum net income of not less than $1 beginning with the quarter ended March 31, 2005.

Former Borrowings

     Amended and Restated Credit Agreement. In 2002, the Company and its HWG, LLC subsidiary entered into a credit agreement with First Bank & Trust, N.A. In 2003 and 2004 the credit agreement was amended and restated (the “Amended and Restated Credit Agreement”) several times and provided additional borrowings to the Company to satisfy its cash flow requirements. The Company repaid all loan facilities under the Amended and Restated Credit Agreement in connection with the sale of HRP in July 2004.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

     Capital Lease Obligations. The Company’s Brock Suite Hotels, Inc. subsidiary had entered into three separate capital leasing agreements for furniture, fixtures and building improvements. The Company repaid all of the capital leases in June 2004.

Note 6 — 10% Collateralized Subordinated Debentures

     Description. The Company had an issue of 10% Collateralized Subordinated Debentures ( the “10% Debentures”) outstanding due July 31, 2005. The 10% Debentures were listed on The New York Stock Exchange.

     Redemption. In August 2004, the Company called the 10% Debentures for redemption and in September 2004, the Company completed the redemption. Debenture holders were paid 100% of the principal amount plus interest through the redemption date of September 30, 2004.

Note 7 — Separation Agreement

     In 1999, the Company entered into a separation agreement with a former officer and director and related trust (the “Separation Agreement”). The Separation Agreement provided that the former officer and director and related trust exchange their 24% common stock ownership in the Company for certain assets and future cash payments, contingent on the net cash flow from the Company’s real estate management activities. The Company had an option to extinguish the future cash payments at any time prior to December 21, 2004 upon the payment of $3,000,000. In June 2004, the Company exercised the option. In the 2004 second quarter, the Company recognized a gain from extinguishment of the Separation Agreement in the amount of $375,000, which was the excess of the recorded obligation over the $3,000,000 exercise price.

Note 8 — Deferred Revenue — Noncompetition Agreement

     In March 2001, the Company agreed to sell its investment in its former subsidiary, Hallwood Energy Corporation (“Former Hallwood Energy”), which represented the Company’s former energy operations, to Pure Resources II, Inc., an indirect wholly owned subsidiary of Pure Resources, Inc. (“Pure”). The Company received $18,000,000 for the tender of its 1,440,000 shares of common stock of Former Hallwood Energy in May 2001 and received an additional $7,250,000, pursuant to 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 from the noncompetition agreement over a three-year period commencing June 2001. Amortization expense was $403,000 and $1,007,000 for the three and six month periods ended June 30, 2004, respectively. The noncompetition agreement was fully amortized in May 2004.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 9 — Income Taxes

     Following is a schedule of the income tax expense (benefit) (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Continuing Operations
Federal
Current		$	650			$	220			$	656			$	221
Deferred			(252	)			(5,206	)			239				(7,891	)
Sub-total			398				(4,986	)			895				(7,670	)
State			475				727				983				1,181
Total		$	873			$	(4,259	)		$	1,878			$	(6,489	)
Discontinued Operations
Federal
Current		$	—			$	—			$	—			$	—
Deferred			—				(2,340	)			—				(9,642	)
Sub-total			—				(2,340	)			—				(9,642	)
State			—				21				—				47
Total		$	—			$	(2,319	)		$	—			$	(9,595	)

     The deferred tax asset was $4,418,000 and $4,657,000 at June 30, 2005 and December 31, 2004, respectively. Prior to 2004, the deferred tax asset was principally attributable to the anticipated utilization of the Company’s net operating loss carryforwards (“NOLs”), percentage depletion carryovers, tax credits and temporary differences from the implementation of various tax planning strategies, which included anticipated gains from the potential sale of investments and projected income from operations. During 2004, the Company utilized its available NOLs, depletion carryforward and tax credits to offset taxable income. At June 30, 2005 and December 31, 2004, the deferred tax asset was attributable solely to temporary differences which can be utilized to offset projected income from operations.

     Income tax expense from continuing operations was $873,000 for the 2005 second quarter, compared to an income tax benefit of $4,259,000 in 2004. The 2005 amount included a noncash deferred federal tax benefit of $252,000, a $650,000 federal current expense and $475,000 expense for state taxes. The 2004 amount included a $5,206,000 noncash federal deferred benefit, a $220,000 federal current expense and $727,000 expense for state taxes. Income tax expense from continuing operations was $1,878,000 for the 2005 six month period, compared to an income tax benefit of $6,489,000 in 2004. The 2005 amount included a $239,000 noncash federal deferred expense, a $656,000 federal current expense and $983,000 expense for state taxes. The 2004 amount included a $7,891,000 noncash federal deferred benefit, a $221,000 federal current expense and $1,181,000 expense for state taxes. 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. Income tax expense in the 2005 periods includes the impact of limitations on the deductibility of executive compensation in excess of $1,000,000 per year.

     In the 2004 six months, as a result of the appreciation in market value of the HRP limited partner units during 2004 and the establishment of a value for the general partner interest in HRP, principally due to the terms of the Agreement and Plan of Merger with HRPT, management determined that the deferred tax asset valuation allowance should be reduced to reflect the anticipated increase in utilization of NOLs and other tax attributes prior to their expiration. To the extent that the elimination of the valuation allowance was attributable to the appreciation in market value of the investments in HRP, the deferred tax benefit was allocated to discontinued operations. Accordingly, the Company recorded a net deferred tax benefit of $17,533,000 in the 2004 six month period, of which $9,642,000 was allocated to discontinued operations.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 10 — Discontinued Real Estate Operations

     Prior to its sale in July 2004, 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, respectively, in its HRP affiliate. The Company accounted for its investment in HRP using the equity method of accounting. The Company’s real estate business segment was reclassified as discontinued operations in the second quarter of 2004.

     In July 2004, the merger with a subsidiary of HRPT was approved by the HRP unitholders at the special meeting of unitholders with holders of 53.74% of the outstanding units voting to approve the merger. The total cash price HRPT paid under the merger agreement and the purchase agreement was approximately $247,000,000. In addition, HRPT assumed or prepaid all of HRP’s outstanding debt. The Company received proceeds of approximately $66,060,000 from the sale of its interests, of which $18,500,000 was placed into an escrow account pending the resolution of certain claims. In December 2004, the pending claims were resolved, and the Company received the full amount of the $18,500,000 escrow deposit plus accrued interest.

     In its announcement, HRP indicated that unitholders received an amount in cash equal to $136.70 per unit of limited partnership. Of this amount $0.31 per unit was withheld subject to the award of attorneys’ fees to the class counsel in the I.G. Holdings Inc. et al v. Hallwood Realty, LLC et al. litigation. Proceeds were also reduced by approximately $102,000 for the Company’s share of the award of attorneys’ fees to the class counsel in the I.G. Holdings litigation. In February 2005, the Company received approximately $59,000, which was its allocable share of the remaining escrow account balance from the I.G. Holdings litigation. A summary of discontinued real estate operations is provided below (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Revenues and Expenses
Revenues
Fees
Related parties		$	—			$	1,239			$	—			$	2,413
Other			—				40				—				66
Equity income (loss) from investments in HRP			—				(134	)			—				178
			—				1,145				—				2,657
Expenses
Administrative expenses			—				304				—				536
Litigation costs			—				18				—				49
			—				322				—				585
Income before income taxes			—				823				—				2,072
Income Taxes
Deferred federal income tax (benefit)			—				(2,340	)			—				(9,642	)
Current federal and state income tax expense			—				21				—				47
			—				(2,319	)			—				(9,595	)
Income from discontinued real estate operations		$	—			$	3,142			$	—			$	11,667

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 11 — Discontinued Hotel Operations

     In December 2004, the Company’s Brock Suite Huntsville, Inc. subsidiary entered into a Lease Termination and Mutual Release Agreement with the landlord of the GuestHouse Suites hotel in Huntsville, Alabama. As of December 31, 2004, the Company had no further operations in the hotel segment. Operating results were reclassified as discontinued operations.

     A summary of discontinued hotel operations is provided below (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Revenues
Sales		$	—			$	380			$	—			$	742
Expenses
Operating expenses			—				520				—				968
Depreciation and amortization			—				31				—				62
Interest expense			—				3				—				9
Litigation and other disposition costs			—				1				—				2
			—				555				—				1,041
Loss from discontinued hotel operations		$	—			$	(175	)		$	—			$	(299	)

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 12 — Supplemental Disclosures to the Condensed Consolidated Statements of Cash Flows

     The following transactions affected recognized assets or liabilities but did not result in cash receipts or cash payments in thousands):

          Supplemental schedule of non-cash investing and financing activities:

		Six Months Ended
		June 30,
Description		2005				2004
Transfer of HPL net assets to officers of the energy affiliates:
Restricted cash		$	218			$	—
Prepaids, deposits and other assets			85				—
Property, plant and equipment, net			588				—
Other noncurrent assets			138				—
Accounts payable			(584	)			—
Accrued expenses and other current liabilities			(445	)			—
		$	—			$	—
Income tax effect from exercise of stock options:
Income taxes payable		$	(1,651	)		$	—
Additional paid-in capital			1,651				—
		$	—			$	—
Proportionate share of partner capital transactions of equity investments:
Amortization of interest rate swap		$	—			$	(30	)

          Supplemental disclosures of cash payments:

		Six Months Ended
		June 30,
Description		2005				2004
Interest paid		$	260			$	392
Income taxes paid			2,121				365

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 13 — Computation of Income (Loss) Per Common Share

     The following table reconciles weighted average shares outstanding from basic to assuming dilution and reconciles the Company’s net income (loss) used in the computation of income per share for the basic and assuming dilution methods (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
Description		2005				2004				2005				2004
Weighted Average Shares Outstanding
Basic			1,431				1,326				1,379				1,326
Potential shares from assumed exercise of stock options			—				204				—				204
Potential repurchase of shares from stock option proceeds			—				(64	)			—				(73	)
Assuming dilution			1,431				1,466				1,379				1,457
Net Income (Loss)
Basic and assuming dilution		$	(4,317	)		$	13,627			$	(3,411	)		$	27,346

     Due to the loss from continuing operations in the 2005 periods, potential shares from assumed exercise of stock options in the amounts of 76,000 and 129,000 shares for the three month and six month periods, respectively, were antidilutive.

Note 14 — Litigation, Contingencies and Commitments

     Reference is made to Note 20 to the consolidated financial statements contained in Form 10-K for the year ended December 31, 2004.

     The Company, certain of its affiliates and others have been named as defendants in several lawsuits relating to various transactions in which it or its affiliated entities participated. The Company intends to defend, or in some cases negotiate to settle, the remaining actions and does not currently anticipate that such actions will have a material adverse effect on its financial condition, results of operations or cash flows.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2005 and 2004
(unaudited)

Note 15 — Segments and Related Information

     The following represents the Company’s reportable segment operations for the three months and six months ended June 30, 2005 and 2004, respectively (in thousands):

		Textile												Discontinued
		Products				Energy				Other				Operations				Consolidated
Three months ended June 30, 2005
Total revenue from external sources		$	35,289			$	568											$	35,857
Operating income (loss)		$	3,433			$	—			$	(7,409	)						$	(3,976	)
Other income (loss), net			(168	)			500				200								532
Income (loss) from continuing operations before income tax		$	3,265			$	500			$	(7,209	)						$	(3,444	)
Three months ended June 30, 2004
Total revenue from external sources		$	35,554															$	35,554
Operating income (loss)		$	6,330			$	—			$	(756	)						$	5,574
Other income (loss), net			(96	)			439				484								827
Income (loss) from continuing operations before income tax		$	6,234			$	439			$	(272	)						$	6,401
Income from discontinued operations														$	2,967			$	2,967
Six months ended June 30, 2005
Total revenue from external sources		$	71,684			$	1,499											$	73,183
Operating income (loss)		$	6,693			$	—			$	(8,853	)						$	(2,160	)
Other income (loss), net			(301	)			194				734								627
Income (loss) from continuing operations before income tax		$	6,392			$	194			$	(8,119	)						$	(1,533	)
Six months ended June 30, 2004
Total revenue from external sources		$	66,794															$	66,794
Operating income (loss)		$	9,662			$	—			$	(1,298	)						$	8,364
Other income (loss), net			(196	)			520				801								1,125
Income (loss) from continuing operations before income tax		$	9,466			$	520			$	(497	)						$	9,489
Income from discontinued operations														$	11,368			$	11,368