The Legal Issues
First, the legal issues. HWG had an Equity Support agreement with Hallwood Energy to invest $12.5 million in Energy. HWG refused to fund the last $3.2 million, claiming there were grounds to terminate the support agreement. Hallwood Energy and its outside investors brought an adversary proceeding against HWG, claiming that HWG violated the agreement and caused the bankruptcy of Hallwood Energy. In July 2011 the Bankruptcy Court issued proposed findings of a judgement against HWG for $18.7 million plus pre and post judgement interest and attorney’s fees. The District Court will issue the final ruling in the case, and could change the judgement in either direction. It is unknown when the District Court will rule.
A second suit stemming from the Hallwood Energy bankruptcy was brought by Hall Phoenix, who were investors in Hallwood Energy. They claimed they were defrauded by HWG regarding the nature of the investment in Hallwood Energy. This suit was settled in February 2012 for $1.8 million and HWG has paid the settlement.
Finally, HWG is also dealing with a suit for patent infringement brought against Brookwood surrounding patents related to military fabrics. Nextec Applications initially filed the suit in 2007, and at one point there were ten patents involved. Brookwood has managed to get the claims regarding eight of the patents thrown out, leaving only two in the case. However, Brookwood filed for those two patents to be reexamined by the US Patent Office. The Patent Office has issued first office actions rejecting the two Nextec patents as unpatentable due to prior art, though Nextex can respond to this action. The trial on this issue is scheduled to begin on April 30th.
The Business
Brookwood converts, finishes, and laminates woven synthetics with plants in Rhode Island and Connecticut. They specialize in producing nylon camouflage fabrics for clothing suppliers to the military. Brookwood entered into the specialty military fabric business in 2000 when they set up a joint venture with Strategic Tactical Alliance, and then proceeded to buy out STA’s stake in the JV in 2002.
Brookwood’s financial results have been volatile over the years, as can be seen in the summary below:
They depend in part on the timing of large military purchases, which are very cyclical and unpredictable. 08-10 were very strong years, but sales to military contractors declined $40.4 million in 2011 and EBIT declined from $24.6 million to $5.5 million. SG&A expense over the past few years is probably $1-2 million higher than a normalized number due to legal expense relating to the NexTec lawsuit.
Expense on the HWG level was $5.3 million in 2011, which is about average for the company. The HoldCo expense has fluctuated due to legal fees, so I have put in the $5.3 million as a normalized number in the table above to calculate EBIT on the HWG level.
Valuation
On an asset basis, HWG certainly looks cheap even if we take a mid-range scenario for the legal outcomes. As of December 31, HWG had reserved $12.5 million for the adversary proceeding and Hall lawsuit. If we assume a $20 million total judgement for the adversary proceeding and the $1.8 million Hall settlement that would add $9.3 million in liabilities to the balance sheet. That gets us to the following book, net working capital, and liquidation values for HWG:
(Liquidation assumes cash valued at 100%, A/R at 90%, inventory at 50%, and PP&E at 35%). Those numbers compare to a current share price of $9.75. So the market is valuing HWG at liquidation value even after accounting for a reasonable legal liability scenario.
There are three unknowns that make it difficult to value HWG: the outcome of the adversary proceeding, the outcome of the patent lawsuit, and the wildly fluctuating results of the Brookwood business.
At least for the adversary proceeding we have the proposed findings of the Bankruptcy Court, although they could be changed by the District Court. If it does come in around $20 million then HWG certainly has the asset value to handle it, although liquidity could be an issue. HWG received a going concern qualification on their 10K due to the adversary proceeding judgement and insufficient cash on the balance sheet to pay it off. HWG had $10.9 million in consolidated cash, but only $6.7 million on the HoldCo level (and only $4.9 million after paying the Hall settlement). Due to an agreement with their lenders, Brookwood can only dividend 50% of their net income up to HWG. Brookwood would have to get a release to from their lenders to send more cash to HWG, which might be an impediment to paying off the judgment, although HWG has other options (take on debt at the HoldCo level or sell some or all of the company’s assets).
The outcome of the patent case might be the biggest risk as it could potentially impair much of the value in the textile business if Brookwood loses. Brookwood appears to be winning the case to date, but that is out of my circle of competence to analyze. And aside from the patent case, it is unclear what the Brookwood business is worth given the very cyclical results and dependence on the military.
If the textile business were more stable it is possible that the risk/reward in HWG at these price levels might be compelling even with the patent risk. But without being able to come an informed opinion about the patent case I think it is hard to invest in HWG with the unclear upside in the Brookwood business and the potential downside in both the patent case and the adversary proceeding.
By: valueslant.com
