The Hallwood Group Incorporated (NYSEMKT:HWG) is a recovering conglomerate. Up until early 2009, it ran both a profitable textile business and an unprofitable energy business (that also had the added attribute of being a lightening rod for lawsuits – more on that later). Thankfully, the company bankrupted the energy subsidiaries and is now operating solely in textile through its subsidiaries, Kenyon Industries (woven synthetic fabrics) and Brookwood Laminating (laminating services for fabrics). HWG is currently trading at a P/E of just 2.3x and 10% below its NCAV, despite having strong operating cash flows and almost no debt. Additionally, I adjusted the last eight years’ of income statements to remove the effects of the energy business and calculated that its PE10 is approximately 4.5, showing that this is hardly a situation of a single year of excess performance.
With all of these positives, what is causing the stock to trade at such depressed levels? It appears to be litigation. The company is engaged in, at my count, six different lawsuits, with several other fines. The bulk of these are related to HWG’s energy business, which though currently in the process of bankruptcy, is engaging in lawsuits with different stakeholders. From my understanding, litigation in the process of bankruptcy is the rule, not the exception and so we should expect that the company will resolve these in the usual course of business. Since the bankruptcy HWG has remained highly profitable with an exceptional amount of free cash flow. The biggest and most important claim is, however, not related to the energy business and instead is aimed directly at the textile business as an alleged patent infringement.
On July 31, 2007, Nextec Applications, Inc. filed Nextec Applications, Inc. v. Brookwood Companies Incorporated and The Hallwood Group Incorporated … claiming that the defendants infringed five United States patents pertaining to internally-coated webs: U.S. Patent No. 5,418,051; 5,856,245; 5,869,172; 6,071,602 and 6,129,978. … Nextec sought leave of Court to add two additional patents to the lawsuit: U.S. Patent No. 5,954,902 and 6,289,841. The Court granted leave to Nextec, and Nextec filed its amended complaint on September 19, 2008.
Now, HWG has already had some success, as seven of the 10 patent claims have been dismissed:
On April 1, 2010, the Court issued its initial Order, following a hearing held on February 17, 2010 on various motions for summary judgment filed by both parties. In the Order, the Court dismissed Nextec’s claims of infringement based on seven of the ten remaining patent claims asserted in the action.
The Nextec lawsuit is a dark cloud hanging over the company and a leading possibility for the company’s current valuation. Some other worrisome facts about HWG for the value investor include its sales concentration, in that sales to the military account for more than 70% of sales (with military sales being split largely between two companies, Tennier Industries and ORC Industries).
Additionally, the company’s CEO has created a company, Hallwood Investments Ltd. (HIL), to enter into a controversial contract for “international consulting and financial advisory services.” This contract awards HIL $996,000 per year and reimburses HIL for reasonable expenses, which in the past have included more than $160,000 for office space and administrative services and more than $150,000 for travel. I have written several times in the past about major founder/family shareholders who treat the company as if it were private, at the expense of unrelated shareholders, and for me this is a big red flag from a value perspective. I do NOT think this is the case here, as Mr. Gumbiner receives no direct compensation from the company. Although the figures are somewhat high, it seems reasonable that Mr. Gumbiner would choose to have his compensation flow into a corporation, possibly for tax purposes.
From my perspective, HWG is undervalued and I think the resolution of the Nextec lawsuit will be a major catalyst event for the company. I take it as a good sign that 7/10 of Nextec’s claims have been dismissed.