Thursday, October 21, 2010

Looks Good, But How Does It Smell?

The Hallwood Group (HWG) produces fabrics and finishing processes for the textile industry. It trades at a P/E of less than 3, with just $4 million of debt against $10 million of cash. Last quarter, the company generated operating income of $7.5 million, while the company trades for just $55 million! This investment looks too good to be true. But does it pass the smell test?

The company is majority-owned and controlled by its CEO Anthony Gumbiner, which can be a good thing. But the good news ends there. From the 10-Q:

"The Company has entered into a financial consulting contract with Hallwood Investments Limited (“HIL”), a corporation associated with Mr. Anthony J. Gumbiner...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...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 and for travel and related expenses to and from the Company’s corporate office and Brookwood’s facilities and health insurance premiums."

All of these consulting, office, travel and other expenses resulted in shareholders forking out almost $400K last quarter in return for such items as "international consulting services".

In addition, while the company is profitable now, it generated less than $1 million of operating income in 2006. While the growth trajectory is admirable, its sustainability must be called into question, particularly considering the company's level of customer concentration. More than 70% of the company's revenue is derived from military applications. Any time one customer accounts for a majority of revenue, this is a significant risk.

But perhaps the company's most significant risk is its inability to get along with others. The company is facing lawsuit after lawsuit from almost everyone it deals with. A lawsuit is on-going with Nextec, which claims Hallwood's coating process infringes on its patents. Minority shareholders have also filed a motion against the company and its directors for trying to rip minority shareholders off last year. (This is an example of why management control can also be a bad thing, as per the second last paragraph here.) FEI Shale is suing the company for not holding up its end of an investment agreement; FEI is suing for punitive damages of $100 million, which is twice Hallwood's current market cap!

And this is just the tip of the iceberg. Many others, from investors to government departments are suing this company. It has gotten to the point that the company's insurer has cut down on what it is willing to pay for costs relating to officer indemnity and legal fees.

A low P/E is great. But sometimes, the risks to the company are so high that even an extremely low P/E can't make a company's risk reward profile positive. The Hallwood Group may be an example of such a situation.

Disclosure: None

1 comment:

Chroma said...

On paper this looked like an incredible value.

Piotrowski F-score 8
Price/Sales .23
ROA 18.7%
ROIC 27.4%
P/E 2.5

But you have provided invaluable information. I was aware of one lawsuit but not several. And I always get nervous about a controlling shareholder/CEO who begins to award himself cushy contracts.

I will pass.

Thanks, Saj.