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, 2006		Commission File Number: 1-8303

The Hallwood Group Incorporated

(Exact name of registrant as specified in its charter)

Delaware		51-0261339
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification Number)
3710 Rawlins, Suite 1500, Dallas, Texas		75219
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (214) 528-5588

Securities Registered Pursuant to Section 12(b) of the Act:

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

Securities Registered Pursuant to Section 12(g) of the Act:

Title of Class
Series B Redeemable Preferred Stock

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in, definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o      Accelerated filer o      Non-accelerated filer þ

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule-405 of the Securities Act. YES o NO þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES o NO þ

Indicate by check mark if the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES o NO þ

     The aggregate market value of the Common Stock, $0.10 par value per share, held by non-affiliates of the registrant as of June 30, 2006, based on the closing price of $112.53 per share on the American Stock Exchange, was $55,075,000.

     1,514,595 shares of Common Stock, $0.10 par value per share, were outstanding at July 31, 2006.

 

 

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, 2006 and December 31, 2005			3
		Condensed Consolidated Statement of Operations for the Six Months Ended June 30, 2006 and 2005			4
		Condensed Consolidated Statements of Operations for the Three Months Ended June 30, 2006 and 2005			5
		Condensed Consolidated Statement of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2006			6
		Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006 and 2005			7
		Notes to Condensed Consolidated Financial Statements			8
2		Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
3		Quantitative and Qualitative Disclosures about Market Risk			29
4		Controls and Procedures			30
PART II — OTHER INFORMATION
1 thru 6		Other Information			31
		Signature Page			32
		Index to Exhibits			33
Certification of the CEO Pursuant to Section 302
Certification of the CFO Pursuant to Section 302
Certification Pursuant to Section 906

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

		June 30,				December 31,
		2006				2005
ASSETS
Current Assets
Cash and cash equivalents		$	15,015			$	16,648
Accounts receivable
Trade and other			18,248				18,987
Related parties			679				616
Inventories			16,834				16,879
Prepaid income taxes			1,459				1,322
Prepaids, deposits and other assets			1,055				831
Deferred income tax			1,029				1,029
			54,319				56,312
Noncurrent Assets
Investments in energy affiliates			42,541				40,854
Property, plant and equipment, net			12,819				11,358
Other assets			293				277
			55,653				52,489
Total Assets		$	109,972			$	108,801
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable		$	9,792			$	7,274
Accrued expenses and other current liabilities			3,523				4,848
Current portion of loans payable			330				352
Income taxes payable			21				9
			13,666				12,483
Noncurrent Liabilities
Long term portion of loans payable			6,308				6,460
Redeemable preferred stock			1,000				1,000
Deferred income tax			397				415
			7,705				7,875
Total Liabilities			21,371				20,358
Stockholders’ Equity
Common stock, issued 2,396,105 and 2,396,103 shares, respectively; outstanding 1,514,595 and 1,511,218 shares, respectively			240				240
Additional paid-in capital			56,395				56,258
Retained earnings			45,097				45,126
Treasury stock, 881,510 and 884,885 shares, respectively; at cost			(13,131	)			(13,181	)
Total Stockholders’ Equity			88,601				88,443
Total Liabilities and Stockholders’ Equity		$	109,972			$	108,801

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

		Six Months Ended
		June 30,
		2006				2005
Revenues
Textile products sales		$	59,473			$	71,684
Administrative fees from energy affiliates			—				1,499
			59,473				73,183
Expenses
Textile products cost of sales			48,817				56,502
Administrative and selling expenses			9,282				18,841
			58,099				75,343
Operating income (loss)			1,374				(2,160	)
Other Income (Loss)
Equity income (loss) from investments in energy affiliates			(1,034	)			194
Interest expense			(251	)			(302	)
Interest and other income			234				848
Adjustment to gain from disposition of HEC			—				(113	)
			(1,051	)			627
Income (loss) before income tax expense			323				(1,533	)
Income tax expense			358				1,878
Net Loss		$	(35	)		$	(3,411	)
Net Loss Per Common Share
Basic		$	(0.02	)		$	(2.47	)
Assuming dilution		$	(0.02	)		$	(2.47	)
Weighted Average Shares Outstanding
Basic			1,513				1,379
Assuming dilution			1,513				1,379

See accompanying notes to condensed consolidated financial statements.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

		Three Months Ended
		June 30,
		2006				2005
Revenues
Textile products sales		$	28,698			$	35,289
Administrative fees from energy affiliates			—				568
			28,698				35,857
Expenses
Textile products cost of sales			23,998				27,822
Administrative and selling expenses			4,632				12,011
			28,630				39,833
Operating income (loss)			68				(3,976	)
Other Income (Loss)
Equity income (loss) from investments in energy affiliates			(684	)			500
Interest expense			(134	)			(168	)
Interest and other income			126				200
			(692	)			532
Loss before income tax expense (benefit)			(624	)			(3,444	)
Income tax expense (benefit)			(125	)			873
Net Loss		$	(499	)		$	(4,317	)
Net Loss Per Common Share
Basic		$	(0.33	)		$	(3.02	)
Assuming dilution		$	(0.33	)		$	(3.02	)
Weighted Average Shares Outstanding
Basic			1,514				1,431
Assuming dilution			1,514				1,431

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, 2006			2,396			$	240			$	56,258			$	45,126				885			$	(13,181	)		$	88,443
Net loss															(35	)											(35	)
Reissuance of treasury shares from exercise of stock options and related income tax effect											137				6				(3	)			50				193
Balance, June 30, 2006			2,396			$	240			$	56,395			$	45,097				882			$	(13,131	)		$	88,601

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,
		2006				2005
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss		$	(35	)		$	(3,411	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			922				934
Equity income/loss from investments in energy affiliates			1,034				(194	)
Deferred tax expense (benefit)			(19	)			239
Proceeds from sale of marketable securities			—				5,836
Loss from investments in marketable securities			—				62
Adjustment to gain from disposition of HEC			—				113
Excess tax benefits from share-based payment arrangements			(137	)			—
Changes in assets and liabilities:
Increase (decrease) in accounts payable			1,966				(1,197	)
Decrease in inventories			45				6,514
(Increase) decrease in accounts receivable			676				(93	)
Increase (decrease) in accrued expenses and other current liabilities			(1,325	)			(567	)
Increase (decrease) in income taxes payable			12				—
Net change in other assets and liabilities			(239	)			(1,048	)
Discontinued operations:
Net change in other assets and liabilities			—				120
Net cash provided by operating activities			2,900				7,308
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in energy affiliates			(2,721	)			(5,669	)
Investments in property, plant and equipment, net			(1,831	)			(1,452	)
Proceeds from sale of investment in HEC			—				387
Discontinued operations:
Proceeds from sale of investments in HRP, net			—				59
Net cash (used in) investing activities			(4,552	)			(6,675	)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from revolving credit facilities, net			—				3,175
Repayment of other bank borrowings and loans payable			(174	)			(177	)
Proceeds from exercise of stock options			56				2,207
Cash dividends on common stock			—				(56,789	)
Excess tax benefits from share-based payment arrangements			137				—
Net cash provided by (used in) financing activities			19				(51,584	)
DECREASE IN CASH AND CASH EQUIVALENTS			(1,633	)			(50,951	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD			16,648				71,549
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	15,015			$	20,598

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, 2006 and 2005
(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 consolidated 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, 2005.

     Comprehensive Income. The Company had no items of other comprehensive income in any period presented. Accordingly, condensed consolidated statements of comprehensive income are not required and have not been provided.

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

     Textile Products. 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 and other 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.

     Textile products accounts for substantially all of the Company’s operating revenues.

     Energy. Prior to January 1, 2006, the Company had investments in Hallwood Energy III, L.P. (“HE III”), Hallwood Energy II, L.P. (“HE II”), Hallwood Energy 4, L.P. (“HE 4”) and Hallwood Exploration, L.P. (“Hallwood Exploration”). The Company owned between 20% and 26% of the entities (between 17% and 21% on a fully diluted basis) and accounted for its investments using the equity method of accounting. HE III was sold in July 2005. Effective December 31, 2005, HE II and Hallwood Exploration were consolidated into HE 4, which was renamed Hallwood Energy, L.P. (“Hallwood Energy”). At the consolidation date, Hallwood Energy was principally involved in acquiring oil and gas leases and drilling, gathering and sale of natural gas in the Barnett Shale formation located in Parker, Hood and Tarrant Counties in Texas and the Barnett Shale and Woodford Shale formations in West Texas and in the Fayetteville Shale formation of East Arkansas, and conducting 3-D seismic surveys over optioned land covering a Salt Dome in South Louisiana in order to determine how best to proceed with exploratory activity.

     Following the completion of the energy consolidation, all energy activities are now conducted by Hallwood Energy. At June 30, 2006, the Company owned approximately 25% (20% after consideration of profit interests) of Hallwood Energy.

     In July 2006, Hallwood Energy completed the sale of a 60% undivided working interest in its oil and gas properties in West Texas and all of its interest in the Parker, Hood and Tarrant County Texas properties to Chesapeake Energy Corporation (“Chesapeake”). Chesapeake assumed operation of these properties. See Note 3.

     Following the July 2006 sale to Chesapeake, Hallwood Energy’s management has classified its energy investments into three identifiable areas: East Arkansas, South Louisiana and West Texas.

     New Accounting Pronouncements. On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payments” using a modified method of prospective application. See Note 5.

     In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting and reporting for income taxes recognized in accordance with SFAS No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. The Company is currently evaluating the impact of FIN 48. The Company will adopt FIN 48 in the first quarter of 2007.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2006 and 2005
(unaudited)

     On May 18, 2006, the State of Texas passed a bill to replace the current franchise tax with a new margin tax to be effective January 1, 2008. The Company estimates the new margin tax will not have a significant impact on tax expense or deferred tax assets and liabilities.

Note 2—Inventories

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

		June 30,				December 31,
		2006				2005
Raw materials		$	5,888			$	6,257
Work in progress			3,576				5,103
Finished goods			8,115				6,093
			17,579				17,453
Less: Obsolescence reserve			(745	)			(574	)
Total		$	16,834			$	16,879

Note 3—Investments in Energy Affiliates

     Investments in energy affiliates as of the balance sheet dates were as follows (in thousands):

Hallwood Energy, L.P.

						Amount at								Income (loss) for the
						which carried at								six months ended
		Cost as of				June 30,				December 31,				June 30,
Description of Investment		June 30, 2006				2006				2005				2006				2005
Hallwood Energy, L.P.
- Limited partner interest		$	43,675			$	42,536			$	40,848			$	(1,034	)		$	(157	)
- General partner interest			6				5				6				—				—
Total		$	43,681			$	42,541			$	40,854			$	(1,034	)		$	(157	)

     At June 30, 2006, the Company owned approximately 25% (20% after consideration of profit interests) of Hallwood Energy. The Company accounts for this investment using the equity method of accounting and records its pro rata share of Hallwood Energy’s net income (loss) and partner capital transactions.

     Effective December 31, 2005, HE II, and Hallwood Exploration were consolidated into HE 4, which was renamed Hallwood Energy. In January 2006, the Company invested an additional $2,721,000 in Hallwood Energy. The equity loss for the six months ended June 30, 2005 is an aggregate of the losses previously reported by HE II, HE 4 and Hallwood Exploration.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2006 and 2005
(unaudited)

     The partners’ capital interests in Hallwood Energy were proportionate to the capital invested in each entity at December 31, 2005. The Company’s initial investment in Hallwood Energy at December 31, 2005 was comprised of its capital contributions to each of the former private energy affiliates, as follows (in thousands):

Entity
HE 4		$	22,325
HE II			14,011
Hallwood Exploration			4,624
Accumulated equity income (loss)			(106	)
Total		$	40,854

     The HE II investment includes a non-cash contribution of $889,000 in July 2005, which was the result of a deemed distribution of the Company’s proportionate share of certain pipe inventory owned by HE III at the time of HE III’s disposition, which was then contributed to HE II as an additional capital investment.

     Following the completion of the energy consolidation on December 31, 2005, all energy activities are conducted by Hallwood Energy. Following the July 2006 sale of its properties in the Fort Worth Basin, Texas (discussed below), Hallwood Energy’s management has classified its energy investments into three identifiable areas: East Arkansas, South Louisiana and West Texas.

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

     A description of Hallwood Energy’s activities are provided below.

          In February 2006, Hallwood Energy entered into a $65,000,000 loan facility and had drawn $40,000,000 as of June 30, 2006. It is anticipated that the facility will be fully drawn by October 2006.

          During the first quarter of 2006, Hallwood Energy entered into a participation agreement (the “Participation Agreement”) with Activa Resources, Ltd. Under the Participation Agreement, upon Activa’s payment of approximately $4,960,000 to Hallwood Energy, which was received in April 2006, Hallwood Energy transferred to Activa an undivided 25% interest in oil and gas leases with respect to 44,219 net acres that Hallwood Energy currently holds in East Arkansas. During the term of the Participation Agreement, Hallwood Energy is designated as operator of the leases. As operator, Hallwood Energy was required to commence actual drilling operations before June 1 for the first of two initial wells. Hallwood Energy has commenced this drilling. Activa agreed to participate to the extent of its participation interest in the two initial wells, and paid 50% of the first $750,000 incurred for costs associated with the drilling, completion and equipping operations in connection with each of the initial wells.

          In addition, the Participation Agreement establishes an area of mutual interest (the “AMI”) potentially covering an area of approximately 184,000 gross acres, which area includes the 44,219 acres. Pursuant to the AMI, Hallwood Energy will have the right to an undivided 75% participation interest, and Activa will have the right to an undivided 25% participation interest, in any additional leases acquired by either of the parties within the AMI. If either party acquires any additional leases covering lands within the AMI, it must offer the other party the right to acquire its participation interest in the leases acquired. The agreement related to the acquisition of additional leases expires in December 2007.

          In April 2006, Hallwood Energy sold a 5% limited partner interest to an affiliate of its lender, which decreased the Company’s ownership interest to 25% (20% after consideration of profit interests).

     In July 2006, Hallwood Energy completed the sale of a 60% undivided working interest in its oil and gas properties in West Texas and all of its interest in the Parker, Hood and Tarrant County Texas properties to Chesapeake. Chesapeake assumed operation of these properties. The purchase price was $39,400,000, including reimbursement of certain development and drilling costs, subject to any post closing adjustments. Completion of the transaction will enable Hallwood Energy to increase its operational focus on its properties in Arkansas and Louisiana and reduce its capital requirements in West Texas while retaining a significant interest in the economic potential of the West Texas properties.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2006 and 2005
(unaudited)

     The following table sets forth summarized statement of operations data for Hallwood Energy for the six months ended June 30, 2006 (in thousands):

Revenues and Other Income
Natural gas sales		$	778
Interest and other income			1,005
Total revenues and other income			1,783
Operating and Other Expenses
Operating expenses			5,408
Depreciation and depletion			420
Other expenses			2
Total operating and other expenses			5,830
Net Loss		$	(4,047	)

Hallwood Energy III, L.P.

As of June 30, 2006

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

2006

2005

2006

2005

Hallwood Energy III, L.P.

- Limited partner interest

N/A

—

—

—

—

$

351

     Prior to the sale of HE III in July 2005 (discussed below), 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) and partner capital transactions. 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 HE III.

     In March 2005, an agreement was entered into with a former officer of the energy affiliates, who was 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 in July 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.

     Sale of HE III. In July 2005, HE III completed a merger with Chesapeake. In exchange for its interest in HE III, the Company received a cash payment of $54,850,000 in July 2005 and received an additional $799,000 in November 2005 from the final working capital adjustment. 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 $889,000, which was contributed to HE II as an additional capital investment. The Company also recorded a receivable in the amount of $470,000 for the settlement of a working capital adjustment with HPL. The receivable is expected to be contributed to Hallwood Energy in 2006 as an additional capital investment.

     Certain of the Company’s officers and directors were investors in HE III. In addition, as members of management of HE III, 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, 2006 and 2005
(unaudited)

Hallwood Energy Corporation

     In December 2004, Hallwood Energy Corporation (“HEC”), a former affiliate, completed a merger with Chesapeake, under which Chesapeake acquired HEC. In connection with the merger, the Company sold its 28% ownership interest (22% after consideration of stock options) of HEC and received a cash payment of $53,793,000. The Company also recorded a receivable in the amount of $500,000 for the settlement of HEC’s working capital. The Company received $387,000 in April 2005 as its share of the working capital and recorded an adjustment to the gain from the disposition of HEC in the amount of $113,000.

Hallwood Petroleum, LLC

     The Company’s former 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 had no financial value. All revenues were credited to, and all costs were borne by, the other energy affiliates with no profit element. All assets nominally in the name of HPL were 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 were not officers of the Company. The transfer was completed in May 2005. HPL was acquired by Hallwood Energy for nominal consideration in connection with the December 31, 2005 consolidation.

Other Entities

     The Company invested nominal amounts in other affiliated entities which principally served as the general partners for the energy affiliates. These entities were included in the energy consolidation on December 31, 2005.

Note 4 — Loans Payable

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

		June 30,				December 31,
		2006				2005
Bank debt
Revolving credit facility, interest at Libor +1.25% - 1.75% or Prime plus 0.25%, due January 2010		$	6,000			$	6,000
Equipment term loans, interest at various rates, due at various dates from March 2007 through February 2009			638				812
Total			6,638				6,812
Current portion			(330	)			(352	)
Noncurrent portion		$	6,308			$	6,460

     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 facility (prior to the renewal discussed below) bore interest at Brookwood’s option of Prime plus 0.25%, or Libor plus 1.75% — 3.00% (variable depending on compliance ratios) and contained various covenants. The interest rate was 7.07% at June 30, 2006. The outstanding balance at June 30, 2006 was $6,000,000 and Brookwood had $16,000,000 of borrowing availability under this facility.

     Equipment Term Loans. Brookwood has a revolving equipment credit facility in an amount up to $3,000,000 with Key Bank. Interest rates for the equipment term loans varied between 5.60% and 8.57% at June 30, 2006. The outstanding balance at June 30, 2006 was $638,000 and Brookwood had $2,362,000 of borrowing availability under this facility.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2006 and 2005
(unaudited)

     Loan Covenants. The Key Working Capital Revolving Credit Facility provides for a total debt to tangible net worth ratio covenant and a covenant that Brookwood shall maintain a quarterly minimum net income of not less than one dollar, beginning with the quarter ended March 31, 2005. Cash dividends and tax sharing payments to the Company are contingent upon Brookwood’s compliance with the covenants contained in the loan agreement. Brookwood was in compliance with its loan covenants for the first two quarters of 2006 and for all quarters in 2005.

     Renewal of Credit Facilities. Both of the Key Bank facilities, which had original maturities of January 2007, were renewed in March 2006 for a period of three years with a new maturity of January 30, 2010. The amounts of the respective facilities and the loan covenants were unchanged; however, the interest rate on the Key Working Capital Revolving Credit Facility was reduced, at Brookwood’s option, to Prime plus 0.25% or Libor + 1.25% - 1.75% (variable depending on compliance ratios).

Note 5 — Stockholders’ Equity

     Stock Options. The Company established the 1995 Stock Option Plan for The Hallwood Group Incorporated which authorized the granting of nonqualified stock options to employees, directors and consultants of the Company. The 1995 Plan authorized options to purchase up to 244,800 shares of common stock of the Company. The exercise prices of all options granted were at the fair market value of the Company’s stock on the date of grant, had an expiration date of ten years from date of grant and were fully vested on the date of grant. In May and June 2005, directors and officers exercised 184,875 options to purchase shares of the Company’s common stock. The Company issued common shares from its treasury stock.

     In May 2006, the estate of a former officer of the Company exercised its remaining options to purchase 3,375 shares of the Company’s common stock. The Company received proceeds of $56,000 from the exercise of these options and reissued the shares out of treasury stock. The $6,000 difference between the option proceeds and the average cost of reissued treasury shares of $50,000 was recorded as an increase in retained earnings.

     At June 30, 2006, the Company had 15,750 fully vested outstanding options, of which 11,250 expire in 2007 and 4,500 expire in 2010. The 1995 Stock Option Plan terminated on June 27, 2005. Options issued prior to the termination are not affected; however, no new options can be issued under the 1995 Plan.

     On January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payments” using a modified method of prospective application. Under SFAS No. 123(R), all forms of share-based payments to employees, including employee stock options, are treated the same as other forms of compensation by recognizing the related cost in the statement of operations. The expense of the award would generally be measured at fair value at the grant date. SFAS No. 123(R) eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25. All options were fully vested as of December 31, 2005. The Company granted no options in the first six months of 2006 or 2005. Because all of the Company’s stock options are fully vested, there was no impact on income before taxes or net income from adopting SFAS No. 123(R).

     Option activity for the six months ended June 30, 2006 and status of outstanding options are as follows:

										Weighted
										Average
						Weighted				Remaining
						Average				Contractual				Aggregate
		Number of				Exercise				Term				Intrinsic
		Options				Price				(in years)				Value
Outstanding, January 1, 2006			19,125			$	15.10
Granted			—				—
Exercised			(3,375	)			16.58
Forfeited			—				—
Outstanding, June 30, 2006			15,750			$	14.79				1.83			$	1,539,000
Options exercisable at June 30, 2006			15,750								1.83			$	1,539,000
Vested at June 30, 2006			15,750								1.83			$	1,539,000

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2006 and 2005
(unaudited)

     The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the 2006 second quarter and the exercise price, multiplied by the number of options).

Note 6 — Income Taxes

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

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Federal
Deferred		$	(269	)		$	(252	)		$	(19	)		$	239
Current			—				650				—				656
Sub-total			(269	)			398				(19	)			895
State			144				475				377				983
Total		$	(125	)		$	873			$	358			$	1,878

     The net deferred tax asset was $632,000 and $614,000 at June 30, 2006 and December 31, 2005, respectively. The deferred tax asset was attributable solely to temporary differences, that upon reversal, can be utilized to offset income from operations. The effective federal tax rate in both periods was 35%. State taxes are determined based upon taxable income apportioned to those states in which the Company does business at their respective tax rates, which vary from 0% to 17%.

Note 7 — 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		2006				2005
Change in accrued capital expenditures accounts payable		$	552				—
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
			—			$	—

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2006 and 2005
(unaudited)

     Supplemental disclosures of cash payments:

		Six Months Ended
		June 30,
Description		2006				2005
Income taxes paid		$	365			$	2,121
Interest paid			316				260

Note 8 — Computation of Loss Per Common Share

     The following table reconciles weighted average shares outstanding from basic to assuming dilution methods (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
Description		2006				2005				2006				2005
Weighted Average Shares Outstanding
Basic			1,514				1,431				1,513				1,379
Potential shares from assumed exercise of stock options			—				—				—				—
Potential repurchase of shares from stock option proceeds			—				—				—				—
Assuming dilution			1,514				1,431				1,513				1,379
Net Loss
Basic and assuming dilution		$	(499	)		$	(4,317	)		$	(35	)		$	(3,411	)

     Due to the losses in the 2006 and 2005 periods, potential shares from assumed exercise of stock options in the amounts of 14,000 and 76,000 shares for the three month periods in 2006 and 2005, respectively, and 14,000 and 129,000 for the six month periods, respectively, were antidilutive.

Note 9 — 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, 2005.

     Litigation. From time to time, the Company, certain of its affiliates and others have been named as defendants in lawsuits relating to various transactions in which it or its affiliated entities participated. In the Company’s opinion, no litigation in which the Company, subsidiaries or affiliates is a party is likely to have a material adverse effect on its financial condition, results of operation or cash flows.

     Environmental Contingencies. A number of jurisdictions in which the Company operates have adopted laws and regulations relating to environmental matters. Such laws and regulations may require the Company to secure governmental permits and approvals and undertake measures to comply therewith. Compliance with the requirements imposed may be time-consuming and costly. While environmental considerations, by themselves, have not significantly affected the Company’s business to date, it is possible that such considerations may have a significant and adverse impact in the future. The Company actively monitors its environmental compliance and while certain matters currently exist, management is not aware of any compliance issues which will significantly impact the financial position, operations or cash flows of the Company.

     In August 2005, the Rhode Island Department of Health (“RIDOH”) issued a compliance order to Brookwood’s subsidiary, Kenyon Industries, Inc. (“Kenyon”), alleging that Kenyon is a non-community water system and ordering Kenyon to comply with the RIDOH program for public water supply systems. Kenyon contested the compliance order and an administrative hearing was held in November 2005. No decision has been rendered. Complying with the RIDOH requirements would necessitate revamping of the plant’s water supply system and associated costs of approximately $100,000.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended June 30, 2006 and 2005
(unaudited)

     In August 2005, Brookwood received a Notice of Alleged Violation from The Rhode Island Department of Environmental Management (“RIDEM”) with notification that Brookwood had failed to comply timely with a requirement to test the destruction efficiency of a thermal oxidizer at its Kenyon plant and that when the test was conducted the equipment was not operating at the required efficiency. Since that time, Brookwood has upgraded and retested the equipment, which met the requirements on the retest. RIDEM has requested additional information regarding the failed test and Brookwood’s remedial actions and has indicated that a financial penalty is possible. Brookwood is cooperating with RIDEM in resolving the issue. Based on the information available to Brookwood, if a financial penalty is imposed, the Company does not believe that it will be material.

     In September 2005, Brookwood accrued $250,000 for anticipated environmental remediation costs in connection with a plan to remove, dewater, transport and dispose of sludge from its lagoons. Brookwood applied for approval with RIDEM and commenced remediation activities, which were completed in July 2006. In the 2006 first quarter, Brookwood accrued an additional $35,000 for remediation costs.

Note 10 — Segments and Related Information

     The following represents the Company’s reportable segment operations for the three months and six months ended June 30, 2006 and 2005, respectively (in thousands):

		Textile
		Products				Energy				Other				Consolidated
Three months ended June 30, 2006
Total revenue from external sources		$	28,698											$	28,698
Operating income (loss)		$	1,401			$	—			$	(1,333	)		$	68
Other income (loss), net			(134	)			(684	)			126				(692	)
Income (loss) before income tax		$	1,267			$	(684	)		$	(1,207	)		$	(624	)
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) before income tax		$	3,265			$	500			$	(7,209	)		$	(3,444	)
Six months ended June 30, 2006
Total revenue from external sources		$	59,473											$	59,473
Operating income (loss)		$	3,876			$	—			$	(2,502	)		$	1,374
Other income (loss), net			(251	)			(1,034	)			234				(1,051	)
Income (loss) before income tax		$	3,625			$	(1,034	)		$	(2,268	)		$	323
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) before income tax		$	6,392			$	194			$	(8,119	)		$	(1,533	)

     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, 2005 annual report. The total assets for the Company’s operating segments have not materially changed since the December 31, 2005 annual report.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAFTA-DR, textiles and apparel originating from CAFTA-DR countries will be duty and quota-free, provided that yarn formed in the U.S. or other CAFTA-DR countries is used to produce the fabric. In addition, the United States recently implemented bilateral free trade agreements with Bahrain, Chile, Australia, Israel, Jordan, Morocco and Singapore. Although these actions have the effect of exposing Brookwood’s market to the lower price structures of the other countries and, therefore, continuing to increase competitive pressures, management is not able to predict their specific impact.

     Energy. Following the sale of Hallwood Energy III, L.P. (“HE III”) in July 2005, the Company’s remaining principal energy affiliates were Hallwood Energy II, L.P. (“HE II”), Hallwood Energy 4, L.P. (“HE 4”) and Hallwood Exploration, L.P. (“Hallwood Exploration”). The Company owned between 20% and 26% of the entities (between 17% and 21% on a fully diluted basis) and accounted for the investments using the equity method of accounting, recording its pro rata share of net income (loss), stockholders’ equity/partners’ capital transactions and comprehensive income (loss). These private companies were principally involved in acquiring oil and gas leases and drilling, gathering and sale of natural gas in the Barnett Shale formation of Parker, Hood and Tarrant Counties in Texas and the Barnett Shale and Woodford Shale formation in West Texas and the Fayetteville Shale formation in East Arkansas, and conducting 3-D seismic surveys over optioned land covering a Salt Dome in South Louisiana in order to determine how best to proceed with exploratory activity. Effective December 31, 2005, the remaining private energy affiliates, were consolidated into HE 4, which was renamed Hallwood Energy L.P. (“Hallwood Energy”). As of June 30, 2006, the Company owned approximately 25% (20% after consideration of profits interests) of Hallwood Energy.

     In July 2006, Hallwood Energy completed the sale of a 60% undivided working interest in its oil and gas properties in West Texas and all of its interest in the Parker, Hood and Tarrant County properties in Texas to Chesapeake Energy Corporation (“Chesapeake”). Chesapeake assumed operation of these properties.

     Refer also to the section “Investments in Energy Affiliates” for a further description of the Company’s energy activities.

     Presentation

     The Company intends the discussion of its financial condition and results of operations that follows to provide information that will assist in understanding its financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect its financial statements.

     Results of Operations

     The net loss for the 2006 second quarter was $499,000, compared to a net loss of $4,317,000 in 2005. Revenue for the 2006 second quarter was $28,698,000, compared to $35,857,000 in 2005.

     The net loss for the 2006 six month period was $35,000 compared to a net loss of $3,411,000 in 2005. Revenue for the 2006 six month period was $59,473,000, compared to $73,183,000 in 2005.

     Revenues

     Textile products sales of $28,698,000 decreased by $6,591,000, or 18.7%, in the 2006 second quarter, compared to $35,289,000 in 2005. Sales for the six month period decreased by $12,211,000, or 17.0%, to $59,473,000, compared to $71,684,000 in 2005. The decreases were principally due to a decrease of sales of specialty fabric to U.S. military contractors, as a result of decreased orders from the military to Brookwood’s customers, because of a limitation by the military for orders of existing products and the adoption of revised specifications for new products to replace the products for which Brookwood’s customers have been suppliers. The decline in military sales was partially offset by Brookwood’s development and marketing of new products and continued upgrade of its production equipment.

     Tennier Industries, Inc. (“Tennier”) accounted for more than 10% of Brookwood’s net sales during both the 2006 and 2005 three month and six month periods. Its relationship with Tennier is ongoing, however, Brookwood expects reduced sales volumes with Tennier in 2006. Sales to Tennier were $7,152,000 and $16,695,000 in the 2006 second quarter and six month periods, respectively, compared to $15,309,000 and $33,485,000 in 2005. Sales to Tennier represented 24.9% and 43.4% of Brookwood’s net sales in the 2006 and 2005 quarters, respectively, and 28.1% and 46.7% in the 2006 and 2005 six month periods, respectively.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     Military sales, including the sales to Tennier, have generally comprised an increased portion of Brookwood’s total sales and a greater share of gross profit until 2005. However, Brookwood expects reduced military sales in 2006. Military sales accounted for $13,186,000 and $28,914,000 in the 2006 second quarter and six month periods, respectively, compared to $18,106,000 and $39,537,000 in 2005. The military sales represented 45.9% and 51.3% of Brookwood’s net sales in the 2006 and 2005 quarters, respectively, and 48.6% and 55.2% in the 2006 and 2005 six month periods, respectively.

     The Company’s former Hallwood Petroleum, LLC subsidiary (“HPL”) commenced operations in October 2004 as an administrative and management company to facilitate recordkeeping and processing for the energy affiliates. All costs were rebilled to energy affiliates with no profit element. 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 in May 2005. Administrative fees from energy affiliates in the 2005 second quarter and six month periods were $568,000 and $1,499,000, respectively.

     Expenses

     Textile products cost of sales of $23,998,000 for the 2006 second quarter decreased by $3,824,000, or 13.7%, compared to $27,822,000 in 2005. For the six month periods, textile products cost of sales of $48,817,000 for 2006 decreased by $7,685,000, or 13.6%, compared to $56,502,000 in 2005. The 2006 decreases principally resulted from reduced sales and changes in product mix, partially offset by increased energy costs of $734,000 and increased freight costs of $197,000. Cost of sales includes all costs associated with the manufacturing process, including but not limited to, materials, labor, utilities, depreciation on manufacturing equipment and all costs associated with the purchase, receipt and transportation of goods and materials to Brookwood’s facilities, including inbound freight, purchasing and receiving costs, inspection costs, internal transfer costs and other costs of the distribution network. Brookwood believes that the reporting and composition of cost of sales and gross margin is comparable with similar companies in the textile converting and finishing industry.

     The reduced gross profit margin for the 2006 second quarter (16.4% versus 21.2%) and six month periods (17.9% versus 21.2%) principally resulted from changes in product mix and higher energy costs.

     Administrative and selling expenses were comprised of the following (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Textile products		$	3,299			$	4,034			$	6,780			$	8,489
Corporate			1,333				7,409				2,502				8,853
Energy			—				568				—				1,499
Total		$	4,632			$	12,011			$	9,282			$	18,841

     Textile products administrative and selling expenses of $3,299,000 for the 2006 second quarter decreased by $735,000, or 18.2%, from the 2005 amount of $4,034,000. For the six months, selling and administrative expenses were $6,780,000, compared to $8,489,000 in 2005. The decreases were primarily attributable to reduced royalties of $573,000 and $1,229,000, partially offset by costs related to the dissolution of an inactive subsidiary of $360,000 and $434,000, in the 2006 second quarter and six month periods, respectively. The textile products administrative and selling expenses included items such as payroll, professional fees, sales commissions, marketing, rent, insurance, travel and royalties. Brookwood conducts research and development activities related to the exploration, development and production of innovative products and technologies. Research and development costs were approximately $334,000 and $160,000 in the 2006 and 2005 six month periods, respectively.

     Corporate administrative expenses were $1,333,000 for the 2006 second quarter, compared to $7,409,000 for 2005. For the six months, corporate expenses were $2,502,000, compared to $8,853,000 in 2005. The decreases of $6,076,000 and $6,351,000 were principally attributable to bonus awards in the 2005 second quarter of $5,000,000 to Mr. Gumbiner and $905,000 to those officers of the Company, other than Mr. Gumbiner, who held options to purchase common stock of the Company, in lieu of amounts such option holders would have received had they exercised their options prior to the record date of the May 2005 cash distributions. Professional fees increased by $76,000 for the 2006 quarter and decreased by $159,000 for the 2006 six month period, compared to the 2005 periods.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     Administrative costs for the energy affiliates in 2005 related to the Company’s former HPL subsidiary (see above).

     Other Income (Loss)

     Equity income (loss) from investments in energy affiliates, relating to the Company’s pro rata share of loss in the affiliates, was comprised of the following (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Hallwood Energy		$	(684	)		$	(16	)		$	(1,034	)		$	(157	)
HE III			—				516				—				351
Total		$	(684	)		$	500			$	(1,034	)		$	194

     The 2006 results for Hallwood Energy include production from two wells in the Fort Worth Basin, while operations in the West Texas, South Louisiana and East Arkansas regions remain in the exploratory stage at June 30, 2006. The West Texas and East Arkansas areas are currently drilling while the first Louisiana well is expected to spud in September 2006.

     The 2005 amounts for Hallwood Energy represents the aggregate results of HE II, HE 4 and Hallwood Exploration for comparability purposes.

     HE III commenced commercial production and sales of natural gas in June 2004. On July 18, 2005, HE III completed a merger with Chesapeake, under which Chesapeake acquired HE III. See Note 3.

     In March 2005, an agreement was entered into with a former officer of the energy affiliates, who was 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 in July 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.

     Interest expense was $134,000 and $251,000 in the 2006 second quarter and six month periods, respectively, compared to $168,000 and $302,000 in the 2005 periods. Interest expense principally relates to Brookwood’s Key Bank revolving credit facility. The decreases in interest expense were principally due to a reduction in the average outstanding loan amount, partially offset by increasing interest rates.

     Interest and other income was $126,000 and $234,000 in the 2006 second quarter and six month periods, respectively, compared to $200,000 and $848,000 in 2005. The 2006 decreases were principally due to reduced interest income earned on lower balances of cash and cash equivalents and lower income from investments in marketable securities which were sold or matured in 2005.

     The Company sold its interest in Hallwood Energy Corporation (“HEC”) in December 2004. At December 31, 2004, the Company recorded a receivable for $500,000 for the anticipated additional amount the Company would receive from the disposition of its HEC investment upon final calculation of HEC’s working capital. In April 2005, the Company received $387,000 as its proportionate share of the working capital. Accordingly, the Company reduced the gain from the disposition of HEC by $113,000 in the 2005 first quarter.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     Income Taxes

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

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Federal
Deferred		$	(269	)		$	(252	)		$	(19	)		$	239
Current			—				650				—				656
Sub-total			(269	)			398				(19	)			895
State			144				475				377				983
Total		$	(125	)		$	873			$	358			$	1,878

     At June 30, 2006, the deferred tax asset was attributable solely to temporary differences, that upon reversal, could be utilized to offset income from operations. The effective federal tax rate in both periods was 35%, while state taxes are determined based upon taxable income apportioned to those states in which the Company does business at their respective tax rates, which vary from 0% to 17%. Income tax expense in the 2005 periods includes a limitation on the deductibility of executive compensation.

     Investments in Energy Affiliates

     At June 30, 2006, the Company owned approximately 25% (20% after consideration of profits interests) of Hallwood Energy.

     On December 31, 2005, the Company had investments in three energy affiliates: HE II, HE 4 and Hallwood Exploration. Investments in two other energy affiliates, HEC and HE III, were sold in December 2004 and July 2005, respectively. Effective December 31, 2005, HE II and Hallwood Exploration were consolidated into HE 4, which was renamed Hallwood Energy.

     The partners’ interests in Hallwood Energy were proportionate to the capital invested in each entity at December 31, 2005. The Company’s investment in Hallwood Energy at December 31, 2005 was comprised of its capital contributions to each of the former affiliates, as follows (in thousands):

Entity
HE 4		$	22,325
HE II			14,011
Hallwood Exploration			4,624
Accumulated equity income (loss)			(106	)
Total		$	40,854

     In January 2006, the Company invested an additional $2,721,000 in Hallwood Energy.

     In February 2006, Hallwood Energy entered into a $65,000,000 loan facility, and had drawn $40,000,000 as of June 30, 2006. It is anticipated that the facility will be fully drawn by October 2006.

     During the first quarter of 2006, Hallwood Energy entered into a participation agreement (the “Participation Agreement”) with Activa Resources, Ltd. Under the Participation Agreement, upon Activa’s payment of approximately $4,960,000 to Hallwood Energy, which was received in April 2006, Hallwood Energy transferred to Activa an undivided 25% interest in oil and gas leases with respect to 44,219 net acres that Hallwood Energy currently holds in East Arkansas. During the term of the Participation Agreement, Hallwood Energy is designated as operator of the leases. As operator, Hallwood Energy was required to commence actual drilling operations before June 1 for the first of two initial wells. Hallwood Energy has commenced this drilling. Activa agreed to participate to the extent of its participation interest in the two initial wells, and paid 50% of the first $750,000 incurred for costs associated with the drilling, completion and equipping operations in connection with each of the initial wells.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     In addition, the Participation Agreement establishes an area of mutual interest (the “AMI”) potentially covering an area of approximately 184,000 gross acres, which area includes the 44,219 acres. Pursuant to the AMI, Hallwood Energy will have the right to an undivided 75% participation interest, and Activa will have the right to an undivided 25% participation interest, in any additional leases acquired by either of the parties within the AMI. If either party acquires any additional leases covering lands within the AMI, it must offer the other party the right to acquire its participation interest in the leases acquired. The agreement related to the acquisition of additional leases expires in December 2007.

     In April 2006, Hallwood Energy sold a 5% limited partner interest to an affiliate of its lender, which decreased the Company’s ownership interest to 25% (20% after consideration of profit interests).

     In July 2006, Hallwood Energy completed the sale of a 60% undivided working interest in its oil and gas properties in West Texas and all of its interest in the Parker, Hood and Tarrant County Texas properties to Chesapeake. Chesapeake assumed operation of these properties. The purchase price was $39,400,000, including reimbursement of certain development and drilling costs, subject to any post closing adjustments. Completion of the transaction will enable Hallwood Energy to increase its operational focus on its properties in Arkansas and Louisiana and reduce its capital requirements in West Texas while retaining a significant interest in the economic potential of the West Texas properties.

     Following the July 2006 sale to Chesapeake, Hallwood Energy’s management has classified its energy investments into three identifiable areas: East Arkansas, South Louisiana and West Texas.

     Management of Hallwood Energy is currently evaluating its drilling plans and capital requirements for the remainder of 2006 and calendar year 2007. In the early stages of the development of its three operating areas, the drilling plans and capital requirements can vary widely and are dependent upon a number of factors, including the availability and cost of drilling rigs, personnel and other services, regulatory requirements, the success of wells previously drilled by the energy entities and third parties, and other risks and uncertainties described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 in the section entitled “Business–Competition, Risks and Other Factors”. Hallwood Energy’s anticipated capital expenditures and capital requirements through December 31, 2006 have been reduced significantly by the July 2006 sale to Chesapeake, including the impact from the sales proceeds as well as the decrease in future capital expenditures in Texas. In addition, results to date in Arkansas have been inconclusive. Hallwood Energy may slow down its plan for capital expenditures for 2006 in this area until it determines how best to exploit its acreage there. Hallwood Energy may also consider additional strategic partnering arrangements for drilling and development.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following table reflects the status of Hallwood Energy’s oil and gas investments as of August 1, 2006:

Delaware

East

South

Basin, West

Description

Arkansas (a)

Louisiana (b)

Texas (c)

Total

Principal focus

Fayetteville Shale

Salt Dome

Barnett and Woodford Shale

Initial funding

3rd Quarter 2005

1st Quarter 2004

3rd Quarter 2004

Company investment

$

43,681,000

(d)

Company ownership percentage (e)

25%/20%

Net acres held (f)

373,000

(h

)

17,300

Operator

Hallwood

Hallwood

Chesapeake

Energy

Energy

Well type: (g)

Horizontal

1

1

2

Vertical

5

2

7

Well status:

Producing

—

—

—

Drilling

3

2

5

Evaluating/completing.

3

1

4

Net production (Mcf/day)

—

—

—

     A description of activities in each area is provided below. Forward looking information is from current estimates by the management of Hallwood Energy, based on existing and anticipated conditions.

     East Arkansas

     The primary objective formation is the Fayetteville Shale, which appears to range in depth from approximately 2,700 to 7,400 feet and to have a thickness of 300 to 700 feet.

     Hallwood Energy commenced drilling activities in the 2006 first quarter and are currently operating with three rigs under long term contract. Hallwood Energy has contracted for two additional rigs beginning January 1, 2007 with two additional rigs by April 2007 and one other rig by July 2007 to bring the East Arkansas rig count to eight by mid-2007.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     South Louisiana

     Hallwood Energy holds options to acquire leases over approximately 20,000 acres to exploit a salt dome oil and gas opportunity in St. James, Ascension and Assumption parishes. Based on the results of the 3-D seismic data that have been analyzed, approximately 4,000 to 8,000 acres are expected to be retained for future development. Hallwood Energy has secured two rigs, the first in September 2006 with a one well commitment and an option on a second well that is expected to be exercised. The second rig will start in November 2006 and is under contract for two years. Additional drilling equipment and funding will be assessed and determined based on the results of the initial wells.

     Delaware Basin, West Texas

     Hallwood Energy sold a 60% interest and transferred operations in these properties to Chesapeake in July 2006. The expectation is that Chesapeake will finish two wells currently drilling and will relocate the two rigs outside the project areas through the remainder of 2006. One vertical well has already been drilled and logged. The logs show 840 feet of Barnett Shale and 320 feet of Woodford Shale. The 2007 budget expectation is that the rig(s) will return in 2007 and drill five gross wells.

     Fort Worth Basin, Texas

     These properties were sold to Chesapeake in July 2006. Hallwood Energy no longer has any involvement in activities related to these properties. Hallwood Energy’s operating revenues in the six months ended June 30, 2006 were from the two producing wells on these properties.

     Hallwood Energy III, L.P. The Company owned approximately 28% (24% after consideration of profit interests) of HE III. The Company accounted for this investment using the equity method of accounting and recorded its pro rata share of HE III’s net income (loss) and partner capital transactions.

     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 net 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, the assets were recorded at net carrying value of approximately $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, 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.

     In December 2004, in connection with the sale of HEC, 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 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.

     HE III commenced commercial production and sales of natural gas in June 2004.

     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.

     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 additional $3,300,000, as a result of the final working capital adjustment settled in October 2005.

     In exchange for its interest in HE III, the Company received a cash payment of $54,850,000 in July 2005 and received an additional $799,000 in November 2005 from the final working capital adjustment. 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 $889,000, which was contributed to HE II as an additional capital investment. The Company also recorded a receivable in the amount of $470,000 for the settlement of a working capital adjustment with HPL. The receivable will be contributed to Hallwood Energy in 2006 as an additional capital investment.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     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 were credited to, and all costs were borne by, the other energy affiliates with no profit element. All assets nominally in the name of HPL were 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 in May 2005. HPL was acquired by Hallwood Energy for nominal consideration in connection with the December 31, 2005 consolidation.

     Critical Accounting Policies

     There have been no changes to the critical accounting policies identified and set forth in the Company’s Form 10-K for the year ended December 31, 2005.

     Related Party Transactions

     Hallwood Investments Limited. The Company has entered into a financial consulting contract with Hallwood Investments Limited (“HIL”), a corporation associated with Mr. Anthony J. Gumbiner, the Company’s chairman and principal stockholder. The contract provides for HIL to furnish and perform international consulting and advisory services to the Company and its subsidiaries, including strategic planning and merger activities, for annual compensation of $996,000 ($954,000 prior to March 2005). The annual amount is payable in monthly installments. The contract automatically renews for one-year periods if not terminated by the parties beforehand. Additionally, HIL and Mr. Gumbiner are also eligible for bonuses from the Company or its subsidiaries, subject to approval by the Company’s or its subsidiaries’ board of directors. The Company also reimburses HIL for reasonable expenses in providing office space and administrative services.

     A summary of the fees and expenses related to HIL and Mr. Gumbiner are detailed below (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Consulting fees		$	249			$	249			$	498			$	491
Office space and administrative services			99				216				204				324
Bonus			—				5,000				—				5,000
Total		$	348			$	5,465			$	702			$	5,815

     In addition, HIL and Mr. Gumbiner perform services for certain affiliated entities that are not subsidiaries of the Company, for which they receive consulting fees, bonuses, stock options, profit interests or other forms of compensation and expenses. The Company recognizes a proportionate share of such compensation and expenses, based upon its ownership percentage in the affiliated entities, through the utilization of the equity method of accounting.

     Beginning January 1, 2005, HIL shares common offices, facilities and certain staff in its Dallas office with the Company. The Company pays certain common general and administrative expenses and charges HIL an overhead reimbursement fee for its allocable share of the expenses. For the three month periods ended June 30, 2006 and 2005, HIL reimbursed the Company $35,000 and $25,000, respectively, for such expenses. For the six month periods ended June 30, 2006 and 2005, HIL reimbursed the Company $74,000 and $50,000, respectively.

     Hallwood Energy. Beginning August 1, 2005, Hallwood Energy and its predecessor entities share common offices, facilities and certain staff in its Dallas office with the Company. Hallwood Energy reimburses the Company for its allocable share of the expenses. For the three month and six month period ended June 30, 2006, Hallwood Energy reimbursed the Company $97,000 and $132,000 for such expenses, respectively.

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

Item 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     Contractual Obligations and Commercial Commitments

     The Company and its subsidiaries have entered into various contractual obligations and commercial commitments in the ordinary course of conducting its business operations, which are provided below as of June 30, 2006 (in thousands):

		Payments Due During the Year Ending December 31,
		2006*				2007				2008				2009				2010				Thereafter				Total
Contractual Obligations
Long term debt		$	178			$	281			$	152			$	27			$	6,000			$	—			$	6,638
Redeemable preferred stock			—				—				—				—				1,000				—				1,000
Operating leases			535				951				924				571				538				1,971				5,490
Total		$	713			$	1,232			$	1,076			$	598			$	7,538			$	1,971			$	13,128