SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

MARK ONE

The Hallwood Group Incorporated

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

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

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 whether the registrant is an accelerated filer (as defined in Rule 12B-2 of the Act). YES o NO þ

     1,326,343 shares of Common Stock, $.10 par value per share, were outstanding at October 29, 2004.

The Hallwood Group Incorporated

TABLE OF CONTENTS

Page 2

THE HALLWOOD GROUP INCORPORATED

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

ASSETS

See accompanying notes to condensed consolidated financial statements.

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THE HALLWOOD GROUP INCORPORATED

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

LIABILITIES AND STOCKHOLDERS’ EQUITY

See accompanying notes to condensed consolidated financial statements.

Page 4

THE HALLWOOD GROUP INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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THE HALLWOOD GROUP INCORPORATED

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

Page 6

THE HALLWOOD GROUP INCORPORATED

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

Page 7

THE HALLWOOD GROUP INCORPORATED

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

Page 8

THE HALLWOOD GROUP INCORPORATED

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

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THE HALLWOOD GROUP INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(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, 2003.

     Continuing Operations. The Company’s principal continuing business operation is textile products. The Company is also a minority investor in several energy affiliates, which in the aggregate are not considered a material business segment.

     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 materials for military applications. Continued development of these fabrics for military, industrial and consumer applications is a key element of Brookwood’s business plan.

     In 2002, the Company invested $3,500,000 in a private energy company, Hallwood Energy Corporation (“HEC”). The Company made additional investments of $1,997,000 in 2003 and $566,000 in 2004. HEC has drilled 46 wells in the Barnett Shale formation of Johnson County, Texas. The Company owns approximately 28% (22% after consideration of stock options) of HEC and accounts for the investment using the equity method of accounting. HEC is the parent company of two wholly owned subsidiaries, Hallwood SWD, Inc. and Hallwood Gathering, Inc. Certain of the Company’s officers and directors are investors and hold stock options in HEC. See Note 3.

     In 2003, the Company committed to invest $1,318,000 in Hallwood Exploration, L.P. (“Hallwood Exploration”), a private energy partnership, of which $659,000 was funded in January 2004 and the remainder in September 2004. The Company owns approximately 20% (16% after consideration of profit interests) of Hallwood Exploration and accounts for the investment using the equity method of accounting. Certain of the Company’s officers and directors are investors and hold a profit interest in Hallwood Exploration. See Note 3.

     In June 2004, the Company invested $453,000 in Hallwood Energy III, L.P. (“HEC III”), a recently formed, private energy partnership. The Company owns approximately 28% (22% after consideration of profit interests) of HEC III and accounts for the investment using the equity method of accounting. Certain of the Company’s officers and directors are investors and hold a profit interest in HEC III. See Note 3.

     In August 2004, Hallwood Petroleum, LLC (“HPL”) was formed as an operating and management company for the benefit of all energy related Hallwood entities. The Company is the sole member of HPL. Operations in HPL commenced in October 2004.

     In September 2004, the Company invested $2,430,000 in Hallwood Energy II, L.P. (“HEC II”), a newly formed, private energy partnership. The Company owns approximately 24% (19% after consideration of profit interests) of HEC II and accounts for the investment using the equity method of accounting. Certain of the Company’s officers and directors are investors and hold a profit interest in HEC II. See Note 3.

     Discontinued Operations. The Company’s former real estate activities were conducted primarily through its wholly owned subsidiaries. One of the subsidiaries served as the general partner of Hallwood Realty Partners, L.P. (“HRP”), a publicly traded master limited partnership. Revenues were generated through the receipt of management fees, leasing

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THE HALLWOOD GROUP INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

commissions and other fees from HRP and third parties and the Company’s 22% pro rata share of earnings (loss) 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. As a result of the merger and sale, HRP would become a wholly-owned subsidiary of HRPT and would no longer be a publicly traded limited partnership. The general partner interest in HRP would also be sold to a HRPT subsidiary in a separate transaction. The merger and sale were completed on July 16, 2004. As a result of the merger and sale, the Company no longer holds any interest in HRP. The Company received approximately $66,060,000 for its interests in HRP. See Note 2.

     Accounting for Marketable Securities. The Company invested in certain marketable securities in the 2004 third quarter, which are classified as trading securities. Accordingly, the securities are reported at fair market value and unrealized gains and losses are included in income on a current basis.

     New Accounting Pronouncements. In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46 - “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003, the FASB issued FIN No. 46 (Revised) (“FIN 46-R”) to address certain FIN 46 implementation issues. This interpretation clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” for companies that have interests in entities that are Variable Interest Entities (“VIE”) as defined under FIN 46. According to this interpretation, if a company has an interest in a VIE and is at risk for a majority of the VIE’s expected losses or receives a majority of the VIE’s expected gains it must consolidate the VIE. FIN 46-R also requires additional disclosures by primary beneficiaries and other significant variable interest holders. For entities acquired or created before February, 2003, this interpretation is effective no later than the end of the first interim or reporting period ending after March 15, 2004, except for those VIE’s that are considered to be special purpose entities, for which the effective date is no later than the end of the first interim or annual reporting period ending after December 15, 2003. For all entities that were acquired subsequent to January 31, 2003, this interpretation is effective as of the first interim or annual period ending after December 15, 2003. The Company has four entities which are currently accounted for utilizing the equity method of accounting, HEC, Hallwood Exploration, HEC II and HEC III. The Company has determined these entities are not required to be consolidated.

     Reclassifications. In connection with the treatment of the real estate operations as a discontinued operation, certain reclassifications have been made to prior year amounts to conform to the classifications in the current year.

Note 2 — Discontinued Real Estate Operations (in thousands)

     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. In addition to recording its share of HRP’s net income (loss), the Company also recorded non-cash adjustments for the elimination of intercompany profits with a corresponding adjustment to equity income, its pro rata share of HRP’s partner capital transactions with corresponding adjustments to additional paid-in capital and its pro rata share of HRP’s comprehensive income (loss). The cumulative amount of such non-cash adjustments, from the original date of investment through the disposition date, resulted in a $1,849,000 decrease in the carrying value of the HRP investment.

     The carrying value of the Company’s investment in the general partner interest of HRP included the value of intangible rights to provide asset management and property management services. The Company amortized that portion of the general partner interest ascribed to the management rights. The value of the intangible rights became fully amortized in October 2003. For the three and nine months ended September 30, 2003, such amortization was $168,000 and $504,000, respectively.

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

     Agreement and Plan of Merger with HRPT Properties Trust. On July 15, 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, and on July 16, 2004, HRP announced the completion of 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. 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 discussed below.

     Proceeds of Sale. The Company had also entered into a purchase agreement, pursuant to which HRPT would purchase the general partner interest in HRP, the 330,432 limited partnership units indirectly owned by the Company, and the interests in each of the other entities through which the Company held interests in HRP, for an aggregate purchase price which was estimated to be approximately $67,000,000, subject to adjustment corresponding to any adjustments in the price being paid for the units in the merger. In addition, the Company and HRP had agreed that the contracts for the management of HRP’s properties by the Company’s affiliates would be terminated at the time of the merger. In the purchase agreement, the Company also agreed to vote all of the units it owned in favor of the merger.

     On July 16, 2004, the Company received proceeds of approximately $66,060,000, of which $18,500,000 was placed into an escrow account described below. 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. The Company used approximately $14,400,000 of the proceeds to repay principal, accrued interest and fees associated with the Amended and Restated Credit Agreement. See Note 4.

     The Company had pledged 300,397 HRP limited partner units to collateralize the Amended and Restated Credit Agreement, which was repaid on the closing date of the merger, and 30,035 units to secure all of the capital leases, which were repaid in June 2004.

     Escrow Agreement. In accordance with the purchase agreement, the Company has deposited $18,500,000 of proceeds from the sale of its interests in HRP into an escrow account pending the resolution of outstanding claims associated with, among others, (i) any breach of the representations and warranties of the Company and its affiliates contained in the purchase agreement, (ii) the transactions contemplated by the purchase agreement or the merger agreement, including the approval of the payment of the purchase price by Hallwood Realty’s audit committee and its board of directors, (iii) the litigation initiated by High River and I.G. Holdings, Inc.; and (iv) any actions incident to any of the above. The escrow deposit is to be held until the earlier to occur of twelve months from the closing of the transactions or the final determination of any claims for indemnity by HRPT.

     I.G. Holdings Litigation. On October 25, 2004, the Delaware Court of Chancery held a hearing on the proposed settlement of the I.G. Holdings litigation and determined that the settlement of this class action was fair, reasonable, adequate and in the best interests of the class and approved it. There was one objection to the settlement but the Court rejected it. The Court also ruled that counsel for the class was entitled to a fee award in an amount of $2,000,000 (which defendants’ insurer had committed to pay), plus recovery of approximately $181,000 in expenses, which would be paid from a $500,000 escrow fund established in connection with the effectuation of the merger pursuant to a court order dated July 15, 2004. The escrow fund reflected the withholding of approximately $0.31 per unit of merger consideration payable to HRP unitholders. The Court of Chancery also determined that a portion of $500,000 should be returned to High River, based on its pro rata ownership of HRP units, and that the balance of the fund would be returned to HRP’s other unitholders based on their pro rata ownership of HRP units. Taking into account the $181,000 payable to class counsel based on their expenses and the approximately $74,000 that was required to be returned to High River, a balance of $245,000 plus interest remained to be distributed to HRP unitholders other than High River. This amount will be reduced by the administrative costs and expenses associated with returning this money to the HRP unitholders (which include the Company). The Company is entitled to approximately $59,000 of this amount (less its pro rata share of the associated expenses). On October 29, 2004, the Delaware Court of Chancery entered an Order and Final Judgment reflecting (among other things) these determinations and its approval of the settlement, as well as its approval of the form and manner of notice of the settlement, certification of the class, release of all defendants and their affiliates and dismissal of the I.G. Holdings litigation with prejudice and on the merits. The Order and Final Judgement is subject to appeal for a 30 day period following its entry.

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

     The Company’s real estate business segment has been reclassified to discontinued operations as a result of the sale of its investments in HRP and the termination of the associated management contracts.

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

     Gain from Sale of Investments in HRP. The gain from sale of investments in HRP of $52,647,000 resulted from the net proceeds of approximately $66,060,000 received in the merger less the carrying value of the investments in the general partnership and limited partnership interests of approximately $13,413,000. The transaction costs and incentive compensation includes legal costs associated with the completion of the transaction and awards of incentive compensation to certain executives.

     Incentive Compensation. A special committee, consisting of independent members of the board of directors of the Company, authorized additional incentive compensation payments of $1,908,000 to Mr. Anthony J. Gumbiner, the Company’s Chairman and Chief Executive Officer; $1,622,000 to Mr. William L. Guzzetti, the Company’s Executive Vice President and $3,000,000 to Hallwood Investments Limited, a company associated with Mr. Gumbiner. These payments were accrued in the 2004 third quarter, of which $4,622,000 was paid in September and $1,908,000 in October 2004.

     Gotham Partners Litigation. As discussed in Note 18 to the consolidated financial statements contained in Form 10-K for the year ended December 31, 2003, the Delaware Court of Chancery rendered its decision after remand regarding the Gotham Partners v. Hallwood Realty, L.P. et al litigation in July 2003. The court determined that the defendants, including the Company, should pay to HRP a judgment of $2,988,000, plus pre-judgment interest of $3,762,000 from August 1995. The judgment amount, which represented the court’s determination of an underpayment by the Company for

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

certain limited partnership units purchased by the Company in 1995 from HRP, was in addition to a judgment amount of $3,417,000 in the Court’s original ruling, and was considered additional purchase price and added to the Company’s investment in the HRP limited partnership units. The interest component of the judgment was recorded as litigation expense, net of the Company’s pro rata share of that amount, which was recorded as income by HRP. The Company also recorded its pro rata share of attorney’s fees paid by HRP to plaintiff’s attorneys, in accordance with the court’s final order and judgment, recorded as an expense by HRP. The Company made a $5,000,000 payment against this obligation in August 2003. In May 2004, the Company made an additional payment of $1,877,000, including interest, in full satisfaction of the obligation. Contemporaneously, the Company entered into a loan agreement with First Bank & Trust for a $1,850,000 term loan to fund the payment. See Note 4.

Note 3 — Investments in Energy Affiliates (dollar amounts in thousands)

     The Company is an investor in several energy affiliates. Provided below is information on these entities.

Hallwood Energy Corporation

     The Company owns approximately 28% (22% after consideration of stock options) of HEC. It accounts for the investment using the equity method of accounting and records its pro rata share of HEC’s net income (loss), stockholders’ equity transactions and comprehensive income (loss) adjustments, if any. HEC is the parent company to two wholly owned subsidiaries, Hallwood SWD, Inc. and Hallwood Gathering Inc.

     The Company invested $3,500,000 in HEC during 2002, $1,997,000 in 2003, and $566,000 in 2004. As of November 1, 2004, HEC has drilled or is 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. At November 1, 2004, 41 wells are producing, one well has been plugged and abandoned, one well is being drilled and two wells are in various stages of completion and/or connection to the gathering system. Additionally, HEC, through its subsidiary Hallwood SWD, Inc. has drilled two and completed one commercial salt water disposal well and completed a disposal facility, which went into operation in April 2004. It serves HEC’s disposal needs, as well as accommodate disposed water from third parties.

     Aggregate natural gas production, as of October 27, 2004, including royalty owner share and partner working interest participation, was approximately 24 million cubic feet per day (approximately 16 million cubic feet per day net to HEC). HEC, through its subsidiary, Hallwood Gathering, Inc., now operates two compression and dehydration facilities (Cleburne and Godley) on the TXU Energy transmission line.

     HEC repaid its $30,000,000 loan facility during the 2004 third quarter and has entered into a $36,000,000 loan facility with a maturity date in December 2004. As of November 1, 2004, HEC had fully drawn the facility. HEC intends to renew the loan facility at maturity if a potential sale of HEC (discussed below) is not completed prior to the maturity date.

     On June 11, 2004, HEC sold to HEC III 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 sale was to a related entity, for accounting purposes the assets were treated as being transferred to HEC III at net carrying value and no gain or loss was reported from the transaction. HEC III limited partnership units are owned in identical proportion to the common share ownership of HEC.

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

     After the sale to HEC III, HEC holds oil and gas leases covering approximately 18,000 gross and 16,000 net acres in Johnson County, Texas.

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

     Loan Participation Agreement. In September 2004, the Company entered into a $6,000,000 pari passu Loan Participation Agreement in connection with HEC’s $36,000,000 loan facility. The Company advanced $2,000,000 to HEC under the Loan Participation Agreement in September 2004 and the remainder of $4,000,000 in October 2004 to fully fund its obligation.

     Sale of HEC. The board of directors of HEC has engaged an advisor to explore a potential sale of HEC. As of November 1, 2004, the advisor has closed its data room for viewing of HEC information and bids have been submitted to HEC, which is continuing discussions with a bidder concerning a definitive agreement.

Hallwood Energy III, L.P.

     The Company owns approximately 28% (22% after consideration of profit interests) of HEC III. It accounts for this investment using the equity method of accounting and records its pro rata share of HEC III’s net income (loss), partner capital transactions and comprehensive income (loss) adjustments, if any.

     In June 2004, the Company invested $453,000 in HEC 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.

     On June 11, 2004, HEC 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 accounting purposes 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, HEC III entered into an agreement with an unrelated third party, which owned approximately 12,000 net acres contiguous to that of HEC III, wherein it assigned a 45% interest in its lease holdings to the unrelated third party, which in turn assigned a 55% interest in its lease holdings to HEC III. Under the joint operating agreement between the two entities, HEC III has been designated as operator for all future development.

     As of November 1, 2004, HEC III has drilled, acquired or is in the process of drilling 13 wells in the Barnett Shale formation in Johnson County, Texas. HEC III commenced commercial production and sales of natural gas in June 2004. Currently, eight wells are producing, one well is being drilled and four wells are in various stages of completion and /or connection to the gathering system.

     HEC III holds oil and gas leases covering approximately 27,000 gross and 14,000 net acres of undeveloped leasehold, predominantly in Johnson County Texas as of November 1, 2004.

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

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

Hallwood Energy II, L.P.

     At September 30, 2004, the Company owns approximately 24% (19% after consideration of profit interests) of HEC II. It accounts for this investment using the equity method of accounting and records its pro rata share of HEC II’s net income (loss), partner capital transactions and comprehensive income (loss) adjustments, if any.

     The Company invested $2,430,000 in HEC II in September 2004. HEC II was formed to explore various oil and gas exploration opportunities, primarily in Texas, and in areas not associated with HEC and HEC III.

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

Hallwood Exploration, L.P.

     At September 30, 2004, the Company owns approximately 20% (16% after consideration of profit interests) of Hallwood Exploration, L.P. (“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.

     The Company invested $1,318,000 in Hallwood Exploration, of which $659,000 was funded in January 2004 and the remainder in September 2004.

     Hallwood Exploration was formed in 2004 to acquire oil and gas properties in Louisiana. Hallwood Exploration has acquired seismic lease options over approximately 28,000 acres, and will conduct a 3-D seismic survey over the optioned land in late 2004 and early 2005 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.

Hallwood Petroleum, LLC

     In August 2004, Hallwood Petroleum, LLC (“HPL”) was created to serve as an operating and management company for the benefit of all of Hallwood’s energy related entities. The Company is the sole member of HPL. Operations in HPL commenced in October 2004.

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

Other Entities

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

Note 4 — Loans and Capital Lease Obligations Payable

     Loans and capital lease obligations payable at the balance sheet dates are as follows (in thousands):

     Further information is provided below:

Textile Products

     Revolving Credit Facility. The Company’s Brookwood subsidiary had a revolving credit facility in an amount up to $17,000,000 with Key Bank National Association (“the Key Working Capital Revolving Credit Facility “). Availability for direct borrowings and letter of credit obligations under the Key Working Capital Revolving Credit Facility were limited to the lesser of the facility amount or the borrowing base, as defined in the agreement. Borrowings were 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 had a maturity date of January 2, 2004, bore interest at Brookwood’s option of prime plus 0.25% or Libor plus 1.75% — 3.00% (variable depending on compliance ratios), contained various covenants, including maintenance of certain financial ratios and restrictions on dividends and repayment of debt or cash transfers to the Company.

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

     This facility was renewed in January 2004 and increased to $22,000,000 with a maturity date of January 2007. The interest rate was 5.00% at September 30, 2004. The outstanding balance was $6,681,000 at September 30, 2004 and Brookwood had approximately $13,421,000 of borrowing base availability.

     Acquisition Credit Facility. The Key Working Capital Revolving Credit Facility provided for a $2,000,000 acquisition revolving credit line. This facility bore interest at Brookwood’s option of prime plus 1.00% or Libor plus 3.25%. Brookwood had borrowed $1,000,000 under this facility. This facility was canceled and rolled into the working capital revolving credit facility in connection with the renewal of the Key Working Capital Revolving Credit Facility in January 2004.

     Equipment Revolving Credit Facility and Term Loans. The Key Working Capital Revolving Credit Facility provided for a $2,000,000 equipment revolving credit line. The facility bore interest at Libor plus 2.75%. In May 2000, Brookwood borrowed $1,000,000 under this credit line, which was converted into a term loan, at a fixed rate of 9.37%, with a maturity date of October 2005. This term loan was repaid in the 2004 third quarter. In February and December 2002, Brookwood borrowed an additional $542,000 and $298,000 under this facility and converted those amounts into term loans, at fixed rates of 5.10% and 4.67%, with maturities of March and December 2007, respectively. In April 2003 and September 2003, Brookwood borrowed $142,000 and $330,000 under this facility and converted those amounts into term loans, at fixed rates of 4.57% and 5.60% with maturities in April 2008 and September 2008, respectively. This facility was increased to $3,000,000 in connection with the renewal of the Key Working Capital Revolving Credit Facility in January 2004. In March 2004, Brookwood borrowed $386,000 under this facility, which was converted into a term loan at a fixed rate of 2.84%, with a maturity in February 2009.

     The outstanding balance at September 30, 2004 was $1,230,000. Brookwood had $1,770,000 availability under this facility.

     Loan Covenants. As of the end of all interim periods in 2004 and as of December 31, 2003, Brookwood was in compliance with its loan covenants. The renewed Key Working Capital Revolving Credit Facility includes 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.

     Subordinated Promissory Note. As part of the purchase price related to the acquisition of an entity in 2000, Brookwood gave the seller a $375,000 subordinated promissory note dated March 2002. The interest free note is being fully amortized over 36 months and has a maturity date of February 2005. The outstanding balance at September 30, 2004 was $42,000.

     Subordinated Secured Promissory Note. Brookwood was a 50% partner in STA with an unrelated third party until September 2002. In September 2002, STA purchased the shares owned by the unrelated third party partner, making STA a wholly owned Brookwood subsidiary, and gave the seller a promissory note in the amount of $596,000. The note bore interest at the prime rate, required a quarterly payment of approximately $85,000 and was repaid in July 2004.

Other

     Term Loan and Revolving Credit Facility. In March 2002, the Company and its HWG, LLC subsidiary entered into a $7,000,000 credit agreement with First Bank & Trust, N.A. The facility consisted of a $3,000,000 term loan and a $4,000,000 revolving credit facility (the “Term Loan and Revolving Credit Facility”). The term loan bore interest at a fixed rate of 7%, matured April 2005 and was fully amortizing, requiring a monthly payment of $92,631. The revolving credit facility bore an interest at the Company’s option of one-half percent over prime, or Libor plus 3.25%. The Company borrowed $500,000 in 2002 and $3,500,000 in 2003 under the facility, principally in connection with investments in HEC. This facility was repaid in July 2004.

     Amended and Restated Credit Agreement. In July 2003, the Company and its HWG, LLC subsidiary entered into an amended and restated credit agreement with First Bank and Trust, N.A. (the “Amended and Restated Credit Agreement”). In addition to incorporating the terms of the Term Loan and Revolving Credit Facility, this facility provided for an additional $3,000,000 term loan and an additional $5,000,000 credit facility.

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

     First Amendment to Amended and Restated Credit Agreement. In January 2004, the Company entered into the First Amendment to Amended and Restated Credit Agreement, whereby terms of the Special Purpose Term Loan were revised. The amendment stipulated that the $3,000,000 commitment would be reduced by $50,000 per month beginning February 2004, and would expire on December 15, 2004 if unused. The revised Special Purpose Term Loan required monthly payments of $50,000 for principal amortization plus interest at the Company’s option of prime plus 0.50% or Libor plus 3.25%, but could not be less than 4.25%. Proceeds from the $3,000,000 term loan (the “Special Purpose Term Loan”) were restricted and were to be used solely to exercise the option associated with the Separation Agreement discussed in Note 6. In June 2004, the Company borrowed $2,750,000 under this loan facility to exercise the option associated with the Separation Agreement. The original terms of the Special Purpose Term Loan provided for interest at a fixed rate of 6%, maturity date of May 2005 and a monthly payment of $48,365.

     Proceeds from the new $5,000,000 credit facility (the “Special Purpose Credit Facility”), drawn in August 2003, were restricted to pay a substantial portion of the litigation judgment in August 2003 in the Gotham Partners v. Hallwood Realty Partners, L.P., et al matter discussed in Note 11. The Special Purpose Credit Facility bore interest at the Company’s option of prime plus 0.50%, or Libor plus 3.25%, but could not be less than 4.25%, and matured May 2005. The Special Purpose Credit Facility did not require principal payments; however, interest was payable monthly. This facility was repaid in July 2004.

     In April 2004, the Company and First Bank & Trust N.A. entered into a commitment agreement. The agreement provides for an additional $1,850,000 term loan, which was to be used solely to pay the remaining amount due to HRP under the litigation judgment in the Gotham Partners matter. The term loan bore interest at the Company’s option of prime plus 0.50%, or Libor plus 3.25%, but could not be less than 4.25% and matured May 2005. The facility was interest only for 120 days; thereafter, monthly principal payments of approximately $31,000 plus interest were required with the balance at maturity. In May 2004, the Company borrowed $1,850,000 under this loan facility to fully satisfy the litigation judgment. This facility was repaid in July 2004.

     Repayment in July 2004. The First Amendment to Amended and Restated Credit Agreement required certain mandatory repayments upon the occurrence of various events, including new debt offerings and the disposition of certain of the Company’s major investments. The Company’s 300,397 HRP limited partner units served as collateral to secure the various facilities. All loan facilities were repaid in July 2004 (principal amount of $14,372,000 at the repayment date) in connection with the sale of HRP. See Note 2.

     Loan Covenants. During all interim periods in 2004 and as of December 31, 2003, the Company was in compliance with all of its loan covenants under the First Amendment to Amended and Restated Credit Agreement.

     Promissory Note. In connection with the settlement of a lawsuit regarding the Company’s former Embassy Suites hotel in Oklahoma City, Oklahoma, the Company issued a non-interest bearing promissory note in June 2003, in the amount of $250,000, payable in equal monthly installments over 18 months. The outstanding balance at September 30, 2004 was $42,000.

     Capital Lease Obligations. During 1999, the Company’s Brock Suite Hotels subsidiaries entered into three separate five-year capital lease agreements for furniture, fixtures and building improvements at a cost of $2,085,000 for three GuestHouse Suites Plus properties. The Company had pledged 30,035 HRP limited partner units as additional collateral to secure the leases. The lease terms commenced January 2000 and were scheduled to expire in December 2004. The combined monthly lease payment was $46,570 and the effective interest rate was 12.18%. In June 2004, the Company repaid the capital leases.

Page 19

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

Note 5 — 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. For financial reporting purposes a pro rata portion of an unamortized gain in the original amount of $353,000 was allocated to the 10% Debentures from a previous debenture issue, and was amortized over its term. As a result, the effective interest rate was 8.9%. Prior to redemption, the 10% Debentures were secured by a junior lien on the capital stock of Brookwood.

     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.

     Balance sheet amounts are presented below (in thousands):

Note 6 — Separation Agreement

     In 1999, the Company entered into a separation agreement (the “Separation Agreement”) with a former officer and director. The Separation Agreement provided that the former officer and director and related trust exchange their 24% stock ownership in the Company for 20% of the Company’s limited partner interest in HRP, 20% of the Company’s common stock interest in the former Hallwood Energy Corporation (“Former Hallwood Energy”), all of the Company’s interest in its condominium hotel business and future cash payments contingent on the net cash flow from the Company’s real estate management activities, that being the lesser of 20% of the net cash flow from its real estate management activities for the preceding quarter, or $125,000. These future cash payments were subject to termination in certain circumstances. 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. The Company recognized a gain from extinguishment of the Separation Agreement in the amount of $375,000, which was the excess of the obligation over the $3,000,000 exercise price.

Note 7 — 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 amount of $7,250,000, pursuant to the terms of a noncompetition agreement that was paid by Pure upon the completion of the merger in June 2001.

     Under the noncompetition agreement, the Company agreed to refrain from taking certain actions (described below) without the prior written consent of Pure and Former Hallwood Energy. These covenants were made by the Company in consideration of the transactions contemplated by the merger agreement with Pure and the payment by Pure to the Company. For a period of three years after the effective date of the merger agreement with Pure, the Company could not, directly or indirectly, engage in certain oil and gas activities in certain geographic areas without the prior consent of Pure. The Company also agreed to keep Former Hallwood Energy’s confidential and proprietary information strictly confidential.

Page 20

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

     The Company began amortizing the deferred revenue from the noncompetition agreement, in the amount of $7,250,000, over a three-year period commencing June 2001. The amortization was $1,007,000 and $1,208,000, in each of the six-month periods ended June 30, 2004 and 2003, respectively. The deferred revenue was fully amortized in May 2004.

Note 8 — Income Taxes

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

     The deferred tax asset was $11,041,000 at September 30, 2004. The deferred tax asset arises principally from the anticipated utilization of the Company’s net operating loss carryforwards (“NOLs”), percentage depletion carryovers and tax credits through a projected gain from the sale of certain energy investments and projected income from operations.

     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, and an increase in projected income from operations due to improved results at Brookwood and the Company’s energy investments, management determined that its valuation allowance should be eliminated to reflect the anticipated increase in utilization of NOLs and other tax attributes prior to their expiration. Deferred tax expense in 2004 was reduced by the elimination of the valuation allowance, which was $19,167,000 at December 31, 2003. 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.

     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.

Page 21

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

Note 9 — 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:

Supplemental disclosures of cash payments:

Note 10 — Computation of Income Per Share

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

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THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

Note 11 — Litigation, Contingencies and Commitments

     Reference is made to Note 18 to the consolidated financial statements contained in Form 10-K for the year ended December 31, 2003.

     Litigation. In June 1997, an action was filed against the Company, HRP, the general partner Hallwood Realty Corporation, a predecessor entity to Hallwood Realty, LLC, and the directors of Hallwood Realty Corporation by Gotham Partners, L.P. in the Delaware Court of Chancery, styled Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., et al. (C.A. No. 15754). This action alleged claims of breach of fiduciary duties, breach of HRP’s partnership agreement and fraud in connection with certain transactions involving HRP’s limited partnership units in the mid 1990’s. The trial court determined that the Company was required to pay $2,988,000 plus pre-judgment interest of approximately $3,762,000. In December 2003, the Delaware Supreme Court affirmed the Court of Chancery’s final order and judgement on remand, effectively ending the matter.

     As discussed in Note 4, the Company entered into an Amended and Restated Credit Agreement, which provided a Special Purpose Credit Facility in the amount of $5,000,000, which was used to pay a portion of the judgment in August 2003. In April 2004, the Company entered into a commitment agreement with First Bank & Trust that provided for an additional $1,850,000 term loan, which was required to be used to pay the remaining amount due to HRP. Funding of the commitment and payment of the amount due HRP occurred in the second quarter of 2004.

     In April 2003, an action was filed against HRP’s general partner, Hallwood Realty, LLC (the “General Partner”), its directors and HRP as nominal defendant by High River Limited Partnership, which is indirectly wholly owned by Carl C. Icahn, in the Court of Chancery of the State of Delaware, styled High River Limited Partnership v. Hallwood Realty, LLC, et al, (C.A. No. 20276) relating to a tender offer by High River for units of HRP. In addition, a putative class action lawsuit was filed against the General Partner, its directors and HRP as nominal defendant by three purported unitholders of HRP in the Court of Chancery of the State of Delaware, styled I.G. Holdings, Inc., et al, v. Hallwood Realty LLC, et al, (C.A. No. 20283) also relating to the High River tender offer.

     On June 30, 2004, the parties to the I. G. Holdings, Inc., et al. v. Hallwood Realty, LLC, et al., action entered into a Memorandum of Understanding providing for the settlement of that putative class action. As contemplated by the Memorandum of Understanding, the parties entered into a Stipulation and Agreement of Compromise, Settlement and Release on July 29, 2004. Pursuant to the Stipulation of Settlement, the parties agreed that the action would be certified, for purposes of settlement only, as a class action consisting of all record and beneficial owners of partnership interests in HRP (other than defendants and their affiliates and associates) on July 16, 2004, the effective date of the merger, that the action would be dismissed with prejudice, and that plaintiffs could make an application for attorneys’ fees and expenses in an amount not to exceed $2,500,000. Defendants agreed not to oppose the fee application. With respect to any fees and expenses awarded by the Court of Chancery, the first $2,000,000 of such amount would be paid by defendants’ insurer and the balance of the amount awarded by the court, if any, would be paid from a $500,000 fund escrowed from the merger consideration pursuant to a court order dated July 15, 2004. On October 25, 2004, the Delaware Court of Chancery held a hearing on the proposed settlement of the class action and determined that the settlement was fair, reasonable, adequate and in the best interests of the class and approved it. There was one objection to the settlement but the Court rejected it. The Court also ruled that counsel for the class was entitled to a fee award in an amount of $2,000,000 (which defendants’ insurer had committed to pay), plus recovery of approximately $181,000 in expenses. The Court of Chancery also determined that a portion of the $500,000 in escrowed funds should be returned to High River, based on its pro rata ownership of HRP units, and that the balance of the fund would be returned to HRP’s other unitholders (including the Company) based on their pro rata ownership of HRP units. Taking into account the $181,000 payable to class counsel based on their expenses and the approximately $74,000 that was required to be returned to High River, a balance of approximately $245,000 plus interest remained to be distributed to HRP unitholders other than High River. This amount will be reduced by the administrative costs and expenses associated with returning this money to the HRP unitholders. On October 29, 2004, the Delaware Court of Chancery entered an Order and Final Judgment reflecting (among other things) these determinations and its approval of the settlement as well as its approval of the form and manner of notice of the settlement, certification of the class, release of all defendants and their affiliates and dismissal of the class action litigation with prejudice and on the merits. The Order and Final Judgement is subject to appeal for a thirty day period following its entry.

Page 23

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

     The Company was a defendant in two lawsuits regarding guaranties of certain obligations of two former hotels. In February 2003, the Company settled both matters. The Company agreed (i) to pay $150,000 in cash and to issue a non-interest bearing promissory note in the amount of $250,000 payable in equal monthly installments over 18 months, in exchange for a full release regarding one of the hotels, and (ii) $250,000 in cash in exchange for a full release regarding the other hotel. In December 2002, the Company recorded an additional loss provision in the amount of $247,000 to fully accrue for these two litigation matters. The Company has made all scheduled payments in accordance with the settlement agreements and the aforementioned promissory note will be fully amortized in December 2004.

     The Company and its subsidiaries are from time to time involved in various other legal proceedings in the ordinary course of their respective businesses. Management believes that the resolution of the aforementioned litigation matters will not have a material adverse effect on the financial condition, results of operations or cash flows of the Company.

     Contingencies. In October 2003, as a result of a voluntary disclosure by Brookwood Laminating, Inc., a subsidiary of Brookwood, the Rhode Island Department of Environmental Management (“RIDEM”) issued a Notice of Violation alleging violations of the Rhode Island Air Pollution Act and seeking an administrative penalty of $379,000. Brookwood Laminating contested the penalty and received a letter from RIDEM in March 2004 proposing to reduce the penalty to $30,000 on the condition that on or before May 1, 2004 it submitted to RIDEM a proposal for the acquisition of certain environmental control equipment at a cost of not less than $400,000. Brookwood submitted a proposal to RIDEM, which approved it, and has purchased and installed the equipment.

     In February 2000, Brookwood, through a wholly owned subsidiary, acquired the assets of a company in a textile products-related industry. The purchase price was $1,479,000 in cash plus contingent payments of up to $3,000,000, based on specified levels of earnings over the next four years. Effective December 31, 2001, in consideration of 36 monthly payments aggregating approximately $375,000, the contingent obligation was reduced to a percentage of cash flow from the acquired subsidiaries, as defined, for the remaining years under the agreement. No amounts have been paid or were owed in relation to this contingency.

Page 24

THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2004 and 2003
(unaudited)

Note 12 — Segment and Related Information

     The following represents the Company’s reportable segment operations for the three months and nine months ended September 30, 2004 and 2003, respectively (in thousands):