A Stock with Hidden Charms

Editor's note: Guest columnist Mark Sellers is a former Morningstar equities strategist and former editor of Morningstar StockInvestor. He now manages the Sellers Capital Fund, based in Chicago.

With soaring energy and real estate prices, many value investors (including hedge fund managers, private equity firms, corporate raiders, and mutual fund managers) have been scouring the marketplace to uncover companies with hidden "real" assets, including real estate, timber, and oil or natural-gas reserves. The assets are considered hidden because they're listed on the balance sheet at cost, even though, in many cases, their market values may be much higher. Over the past couple years many of these asset plays have shot up in value on takeover speculation (or outright takeover bids).

In April, I wrote about Intrawest Corporation , a stock with undervalued real estate on its balance sheet. The stock has since risen about 20% as the market has begun to price in the intrinsic value of this real estate.

Another stock with hidden assets is Hallwood Group . In Hallwood's case, the hidden assets are the company's natural-gas reserves. (Please note: My investment fund owns some of the company's shares, so I may be biased in my analysis and opinion.)

Company Profile
Hallwood Group is a holding company formed in 1981. The firm has two divisions: textile and energy. Though Hallwood has been around for a long time, few investors have heard of it. No analysts cover the stock, and insiders control about 68% of the shares. In 2003, the company was involved in a battle with financier Carl Icahn. Icahn lost the battle, but succeeded in forcing Hallwood to auction off its publicly traded real-estate division, Hallwood Realty Partners, for about $300 million. At the time, Hallwood owned 22% of this division, so it received $66 million cash from the sale. Last month, Hallwood paid most of this cash out to shareholders in a special one-time dividend of $37.70 per share.

After the dividend, the company has no debt (net of cash) on its balance sheet, has a textile division that makes fabric for military uniforms that is worth approximately $50 per share, and owns leases on land containing natural gas worth around $65 per share. That adds up to $115 a share, a 45% premium to the stock's recent price of $79.

Valuation
Calculating a value for Hallwood isn't rocket science. All you have to do is add up the parts (and there aren't many).

After backing out the cash sitting on its balance sheet, Hallwood has no net debt, so we can focus on the valuation of the remaining assets without subtracting debt from the value. Let's add up the two parts of the firm's operations:

Textile Operations
The textile division of Hallwood, named Brookwood, makes specialty fabrics that are primarily used in military uniforms. Over the past two years, Brookwood's sales have grown 60% because of the increased demand for U.S. military uniforms. A big issue with U.S. textile companies this year has been the dramatic increase of low-cost Chinese imports due to the elimination of quotas on textile imports. However, because 56% of Brookwood's revenue comes from military contractors that can only buy from U.S. suppliers, it does not seem to have been affected very much by this development.

Brookwood's pretax operating income was $2.7 million in 2002, $6.7 million in 2003, and $18.5 million in 2004.

Brookwood continues to grow at a good clip, with revenue up 17% in the quarter that ended March 31, though margins were hurt by one-time charges and bonus payouts. To value the textile division, let's be conservative. After all, this is the textile industry, and a textile company doesn't deserve a high P/E no matter how fast it's growing.

I'll assume "normalized" earnings for Brookwood are $12 million pretax (33% less than last year's earnings). This works out to about $8 million after taxes. Let's assign this business a conservative multiple of 10 times aftertax net income, despite the growth rate. That puts the value of Brookwood at around $80 million. 

Energy Operations
Since January 2002, Hallwood has invested more than $20 million in various private energy affiliates. These affiliates are engaged in natural gas exploration and drilling in the Barnett Shale formation of Johnson County, Texas. Also, one affiliate is conducting a 3-D seismic survey over optioned land in South Louisiana to determine if further oil and gas exploration is warranted. Hallwood owns between 16% and 22% of each of these three energy affiliates.

A fourth energy affiliate, which held leases on 18,000 acres on top of the Barnett Shale formation in Texas, was sold in December 2004 to Chesapeake Energy . Chesapeake is one of the largest independent producers of natural gas in the U.S. The sale price was $280 million, or about $15,500 per acre. Hallwood owned 22% of the affiliate, so it received approximately $60 million cash from the sale.

Based on my research, it appears that one of Hallwood's three remaining oil and gas affiliates is worth at least as much as the affiliate that was sold to Chesapeake. The remaining property is on 15,000 acres adjacent to the property that was sold. If I'm correct in my analysis, this would put the value of Hallwood's 22% interest in this affiliate at roughly $55 million-$65 million, or about $17,500 per acre.

The other two oil and gas affiliates on Hallwood's books are tough to place a value on. One of these affiliates holds leases on 30,000 acres of undeveloped land in Texas, twice the number of acres of the affiliate I valued above. However, the company has not said (or does not yet know) how much natural gas is underneath these 30,000 acres, forcing investors to guess. Drilling is expected to commence in the second half of 2005. To be conservative, I estimate that Hallwood’s 22% interest in this affiliate is worth one third of the other one, or $20 million, even though there are twice as many acres. This works out to $3,000 per acre.

The third energy affiliate holds options to lease 28,000 acres of land in Louisiana. Drilling on this land is expected to commence next year, but again, the company doesn't yet know how much gas there is to be drilled. I'll be conservative again and value Hallwood’s 16% interest in this land at $10 million, or $2,200 per acre.

Add the three remaining affiliates up and you get a value of $85 million-$95 million for the energy affiliates.

Adding the textile operations ($80 million) and the energy affiliates together produces a total value of between $165 million and $175 million for the company, net of all liabilities. There are 1.5 million shares outstanding. That puts the total value of Hallwood at around $115 per share, a 45% premium to the current price of $79.

Catalyst
Just because Hallwood appears to be undervalued doesn't mean its stock will go up. There needs to be a catalyst to unlock the value. Luckily, there is a catalyst: I believe the management team is going to buy out the minority shareholders. 

I came to this conclusion based on the following logic. First, management already owns 70% of the stock. Hallwood sold its real estate affiliate and one of its natural gas affiliates last year. It paid most of this cash out to shareholders in the form of a special dividend, which was tax-advantaged because it was considered a "return of capital" for tax purposes. Because management owns 70% of the shares, it received 70% of the special dividend. The members of the management team received, in aggregate, about $39 million. Using this cash plus a bit of debt, management could make a bid for the remaining shares at a premium to the current price.

Alternatively, management may decide to sell off the textile division and focus its efforts on running the energy affiliates. I don't see this as the most likely scenario, but it is a possibility because it would allow insiders to pay another special dividend to shareholders (in other words, to themselves).

Finally, if Hallwood discovers large gas reserves under its Texas or Louisiana acreage, the value of the company would increase dramatically. However, there's no way to know whether this will happen, so I don't factor it into my analysis.

I think it's unlikely that the company will remain as it is today, a mini-conglomerate that continues operating two disparate divisions with no synergies. It's a weird corporate structure and management has already shown willingness to sell off assets to generate shareholder value.

Risks
There are definitely some risks here, mostly related to the management team.

First, the insiders control the company because of their 67% stake. In the past this management team has shown a propensity to ignore minority shareholders and take large "special" bonuses when times are good. They aren't exactly shareholder-friendly.

Second, there are some conflicts of interest because management has personal investments in the same affiliates that Hallwood does. If a choice has to be made between what's good for the affiliates, or what's good for Hallwood, which side will management take? It's not entirely clear.

And of course, the shares are relatively illiquid, making it hard to get in and out quickly. This is not a stock you want to buy if you think you might need to sell in a hurry.

Given these risks, some investors may conclude that Hallwood isn't cheap enough to get involved in, even at a discount to its intrinsic value. It's a valid argument and I certainly don't think this stock is appropriate for everyone. That said, I believe the risk/reward tradeoff is good at the current price, and that's why I hold the shares.