<PAGE>   1
================================================================================


                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                           ---------------------------


                                    FORM 10-Q



MARK ONE

[X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934

[ ]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934

       FOR THE TRANSITION PERIOD from           TO
                                      ---------    ---------


FOR THE PERIOD ENDED JUNE 30, 1998               COMMISSION FILE NUMBER:  1-8303


                      ------------------------------------


                         THE HALLWOOD GROUP INCORPORATED
             (Exact name of registrant as specified in its charter)


                      ------------------------------------



         DELAWARE                                            51-0261339
(State or other jurisdiction of                           (I.R.S. Employer
 incorporation or organization)                         Identification Number)



       3710 RAWLINS, SUITE 1500
           DALLAS, TEXAS                                      75219
(Address of principal executive offices)                    (Zip Code)




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


                  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  X     NO 
                                                      ---       ---

                  1,255,000 shares of Common Stock, $.10 par value per share, 
were outstanding at July 31, 1998.

================================================================================

<PAGE>   2
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                               TABLE OF CONTENTS


<TABLE>
<CAPTION>
     ITEM NO.                                                                                        PAGE
     --------                                                                                        ----
     <S>        <C>                                                                                  <C>
                                   PART I - FINANCIAL INFORMATION

         1      Financial Statements (Unaudited):

                   Consolidated Balance Sheets as of June 30, 1998
                      and December 31, 1997   . . . . . . . . . . . . . . . . . . . . . . . .          3-4

                   Consolidated Statements of Operations for the
                      Six Months Ended June 30, 1998 and 1997   . . . . . . . . . . . . . . .          5-6

                   Consolidated Statements of Operations for the
                      Three Months Ended June 30, 1998 and 1997   . . . . . . . . . . . . . .          7-8

                   Consolidated Statements of Cash Flows for the
                      Six Months Ended June 30, 1998 and 1997   . . . . . . . . . . . . . . .            9

                   Notes to Consolidated Financial Statements   . . . . . . . . . . . . . . .        10-15

         2         Managements's Discussion and Analysis of
                      Financial Condition and Results of Operations   . . . . . . . . . . . .        16-21



                            PART II - OTHER INFORMATION

     1 thru 6      Exhibits, Reports on Form 8-K and Signature Page   . . . . . . . . . . . .        22-28
</TABLE>





                                     Page 2
<PAGE>   3
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

                                     ASSETS

<TABLE>
<CAPTION>
                                                                                  JUNE 30,      DECEMBER 31,
                                                                                   1998            1997  
                                                                                  --------      -----------
ASSET MANAGEMENT                                                                (unaudited)
<S>                                                                               <C>            <C>
   REAL ESTATE
      Investments in HRP  . . . . . . . . . . . . . . . . . . . . . . . . . .      $ 7,227        $ 7,197
      Receivables and other assets  . . . . . . . . . . . . . . . . . . . . .        1,127          1,063
                                                                                   -------        -------
                                                                                     8,354          8,260

   ENERGY
      Oil and gas properties, net   . . . . . . . . . . . . . . . . . . . . .       10,099          9,589
      Current assets of HEP   . . . . . . . . . . . . . . . . . . . . . . . .        2,536          2,657
      Noncurrent assets of HEP  . . . . . . . . . . . . . . . . . . . . . . .        1,615          1,859
      Receivables and other assets  . . . . . . . . . . . . . . . . . . . . .           86            434
                                                                                   -------        -------
                                                                                    14,336         14,539
                                                                                   -------        -------

          Total asset management assets . . . . . . . . . . . . . . . . . . .       22,690         22,799

OPERATING SUBSIDIARIES
   TEXTILE PRODUCTS
      Inventories   . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       15,444         17,935
      Receivables   . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       14,864         14,296
      Property, plant and equipment, net  . . . . . . . . . . . . . . . . . .        8,657          9,057
      Other   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          903            938
                                                                                   -------        -------
                                                                                    39,868         42,226
   HOTELS
      Properties, net   . . . . . . . . . . . . . . . . . . . . . . . . . . .       13,919         14,168
      Receivables and other assets  . . . . . . . . . . . . . . . . . . . . .        1,906          1,742
                                                                                   -------        -------
                                                                                    15,825         15,910
                                                                                   -------        -------

          Total operating subsidiaries assets . . . . . . . . . . . . . . . .       55,693         58,136

OTHER
      Cash and cash equivalents   . . . . . . . . . . . . . . . . . . . . . .        2,937          4,737
      Deferred tax asset, net   . . . . . . . . . . . . . . . . . . . . . . .        2,040          2,040
      Other   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        1,144          1,557
      Restricted cash   . . . . . . . . . . . . . . . . . . . . . . . . . . .          647            489
                                                                                   -------        -------

          Total other assets  . . . . . . . . . . . . . . . . . . . . . . . .        6,768          8,823
                                                                                   -------        -------

          TOTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      $85,151        $89,758
                                                                                   =======        =======
</TABLE>





                                     Page 3
<PAGE>   4
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

                      LIABILITIES AND STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                                 JUNE 30,       DECEMBER 31,
                                                                                   1998             1997   
                                                                               ----------       -----------
                                                                                (unaudited)
<S>                                                                            <C>              <C>
ASSET MANAGEMENT
   REAL ESTATE
      Accounts payable and accrued expenses   . . . . . . . . . . . . . . . .  $    1,263       $    1,295
      Loan payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         500              500
                                                                               ----------       ----------
                                                                                    1,763            1,795
   ENERGY
      Long-term obligations of HEP  . . . . . . . . . . . . . . . . . . . . .       4,787            4,731
      Loan payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       3,067            3,867
      Current liabilities of HEP  . . . . . . . . . . . . . . . . . . . . . .       2,803            2,793
      Accounts payable and accrued expenses   . . . . . . . . . . . . . . . .         608              548
                                                                               ----------       ----------
                                                                                   11,265           11,939
                                                                               ----------       ----------
          Total asset management liabilities  . . . . . . . . . . . . . . . .      13,028           13,734

OPERATING SUBSIDIARIES
   TEXTILE PRODUCTS
      Loan payable  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      12,100           13,800
      Accounts payable and accrued expenses   . . . . . . . . . . . . . . . .       6,909            7,771
                                                                               ----------       ----------
                                                                                   19,009           21,571
   HOTELS
      Loans payable   . . . . . . . . . . . . . . . . . . . . . . . . . . . .      11,942           12,019
      Accounts payable and accrued expenses   . . . . . . . . . . . . . . . .       1,526            1,607
                                                                               ----------       ----------
                                                                                   13,468           13,626
                                                                               ----------       ----------
          Total operating subsidiaries liabilities  . . . . . . . . . . . . .      32,477           35,197

OTHER
      7% Collateralized Senior Subordinated Debentures  . . . . . . . . . . .      21,770           24,292
      Interest and other accrued expenses   . . . . . . . . . . . . . . . . .         756            1,364
                                                                               ----------       ----------
          Total other liabilities . . . . . . . . . . . . . . . . . . . . . .      22,526           25,656
                                                                               ----------       ----------
          TOTAL LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . .      68,031           74,587

REDEEMABLE PREFERRED STOCK
      Series B, 250,000 shares issued and outstanding;
           stated at redemption value . . . . . . . . . . . . . . . . . . . .       1,000            1,000

STOCKHOLDERS' EQUITY
      Preferred stock, 250,000 shares issued and outstanding as Series B  . .          --               --
      Common stock, issued 1,597,204 shares at both dates;
          outstanding 1,254,751 and 1,261,757 shares, respectively  . . . . .         160              160
      Additional paid-in capital  . . . . . . . . . . . . . . . . . . . . . .      54,823           54,823
      Accumulated deficit   . . . . . . . . . . . . . . . . . . . . . . . . .     (29,494)         (31,693)
      Treasury stock, 342,453 and 335,447 shares, respectively, at cost   . .      (9,369)          (9,119)
                                                                               ----------       ---------- 

          TOTAL STOCKHOLDERS' EQUITY  . . . . . . . . . . . . . . . . . . . .      16,120           14,171
                                                                               ----------       ----------

          TOTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  $   85,151       $   89,758
                                                                               ==========       ==========
</TABLE>





                                     Page 4
<PAGE>   5
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                                 (IN THOUSANDS)
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                      SIX MONTHS ENDED
                                                                                          JUNE 30,        
                                                                                  ------------------------
                                                                                   1998             1997   
                                                                                  --------        ---------
<S>                                                                               <C>             <C>
ASSET MANAGEMENT
   REAL ESTATE
      Fees  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     $  2,635        $ 2,518
      Equity income from investments in HRP   . . . . . . . . . . . . . . . .          366            406
                                                                                  --------        -------
                                                                                     3,001          2,924

      Administrative expenses   . . . . . . . . . . . . . . . . . . . . . . .        1,015          1,114
      Depreciation and amortization   . . . . . . . . . . . . . . . . . . . .          336            336
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           58             80
                                                                                  --------        -------
                                                                                     1,409          1,530
                                                                                  --------        -------
          Income from real estate operations  . . . . . . . . . . . . . . . .        1,592          1,394

   ENERGY
      Gas revenues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        1,845          1,710
      Oil revenues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          743          1,020
      Other income  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           74            224
                                                                                  --------        -------
                                                                                     2,662          2,954

      Operating expenses  . . . . . . . . . . . . . . . . . . . . . . . . . .          800            660
      Depreciation, depletion and amortization  . . . . . . . . . . . . . . .          686            627
      Administrative expenses   . . . . . . . . . . . . . . . . . . . . . . .          446            508
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          275            224
                                                                                  --------        -------
                                                                                     2,207          2,019
                                                                                  --------        -------
          Income from energy operations . . . . . . . . . . . . . . . . . . .          455            935
                                                                                  --------        -------

          Income from asset management operations . . . . . . . . . . . . . .        2,047          2,329

OPERATING SUBSIDIARIES
   TEXTILE PRODUCTS
      Sales   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       45,612         50,484

      Cost of sales   . . . . . . . . . . . . . . . . . . . . . . . . . . . .       39,442         43,548
      Administrative and selling expenses   . . . . . . . . . . . . . . . . .        4,532          4,658
      Interest    . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          548            528
                                                                                  --------        -------
                                                                                    44,522         48,734
                                                                                  --------        -------
          Income from textile products operations . . . . . . . . . . . . . .        1,090          1,750
</TABLE>





                                     Page 5
<PAGE>   6
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                      SIX MONTHS ENDED
                                                                                          JUNE 30,        
                                                                                  ------------------------
                                                                                   1998            1997   
                                                                                  --------       ---------
<S>                                                                               <C>            <C>
OPERATING SUBSIDIARIES (CONTINUED)
   HOTELS
      Sales   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     $ 10,346       $ 11,436

      Operating expenses  . . . . . . . . . . . . . . . . . . . . . . . . . .        8,980          9,029
      Depreciation and amortization   . . . . . . . . . . . . . . . . . . . .        1,338          1,374
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          501            732
                                                                                  --------       --------
                                                                                    10,819         11,135
                                                                                  --------       --------
          Income (loss) from hotel operations . . . . . . . . . . . . . . . .         (473)           301
                                                                                  --------       --------

          Income from operating subsidiaries  . . . . . . . . . . . . . . . .          617          2,051

ASSOCIATED COMPANY
      Income from investment in ShowBiz   . . . . . . . . . . . . . . . . . .           --         19,416

      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           --            607
                                                                                  --------       --------

          Income from associated company  . . . . . . . . . . . . . . . . . .           --         18,809

OTHER
      Litigation settlement   . . . . . . . . . . . . . . . . . . . . . . . .        1,025             --
      Fee income  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          275            285
      Interest on short-term investments and other income   . . . . . . . . .          204            574
                                                                                  --------       --------
                                                                                     1,504            859

      Administrative expenses   . . . . . . . . . . . . . . . . . . . . . . .        1,360          1,377
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          459          2,220
                                                                                  --------       --------
                                                                                     1,819          3,597
                                                                                  --------       --------

          Other loss, net . . . . . . . . . . . . . . . . . . . . . . . . . .         (315)        (2,738)
                                                                                  --------       -------- 

      Income before income taxes and extraordinary gain   . . . . . . . . . .        2,349         20,451
      Income taxes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          207          9,726
                                                                                  --------       --------

      Income before extraordinary gain  . . . . . . . . . . . . . . . . . . .        2,142         10,725
      Extraordinary gain from extinguishment of debt  . . . . . . . . . . . .          107            877
                                                                                  --------       --------

NET INCOME  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     $  2,249       $ 11,602
                                                                                  ========       ========

PER COMMON SHARE
   BASIC
      Income before extraordinary gain  . . . . . . . . . . . . . . . . . . .     $   1.67       $   6.87
      Extraordinary gain from extinguishment of debt  . . . . . . . . . . . .         0.08           0.57
                                                                                  --------       --------
          Net income  . . . . . . . . . . . . . . . . . . . . . . . . . . . .     $   1.75       $   7.44
                                                                                  ========       ========
   ASSUMING DILUTION
      Income before extraordinary gain  . . . . . . . . . . . . . . . . . . .     $   1.60       $   6.74
      Extraordinary gain from extinguishment of debt  . . . . . . . . . . . .         0.08           0.56
                                                                                  --------       --------
          Net income  . . . . . . . . . . . . . . . . . . . . . . . . . . . .     $   1.68       $   7.30
                                                                                  ========       ========
</TABLE>





                                     Page 6
<PAGE>   7
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                                 (IN THOUSANDS)
                                  (UNAUDITED)

<TABLE>
<CAPTION>                                                                            
                                                                                     THREE MONTHS ENDED
                                                                                          JUNE 30,        
                                                                                  ------------------------
                                                                                   1998             1997   
                                                                                  --------       ----------
<S>                                                                               <C>            <C>
ASSET MANAGEMENT
   REAL ESTATE
      Fees  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     $  1,393       $  1,545
      Equity income from investments in HRP   . . . . . . . . . . . . . . . .          428            316
                                                                                  --------       --------
                                                                                     1,821          1,861

      Administrative expenses   . . . . . . . . . . . . . . . . . . . . . . .          460            579
      Depreciation and amortization   . . . . . . . . . . . . . . . . . . . .          168            168
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           --             40
                                                                                  --------       --------
                                                                                       628            787
                                                                                  --------       --------
          Income from real estate operations  . . . . . . . . . . . . . . . .        1,193          1,074

   ENERGY
      Gas revenues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          982            648
      Oil revenues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          317            395
      Other income  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           24            146
                                                                                  --------       --------
                                                                                     1,323          1,189

      Operating expenses  . . . . . . . . . . . . . . . . . . . . . . . . . .          401            332
      Depreciation, depletion and amortization  . . . . . . . . . . . . . . .          309            318
      Administrative expenses   . . . . . . . . . . . . . . . . . . . . . . .          221            233
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          129            104
                                                                                  --------       --------
                                                                                     1,060            987
                                                                                  --------       --------
          Income from energy operations . . . . . . . . . . . . . . . . . . .          263            202
                                                                                  --------       --------

          Income from asset management operations . . . . . . . . . . . . . .        1,456          1,276

OPERATING SUBSIDIARIES
   TEXTILE PRODUCTS
      Sales   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       22,297         26,979

      Cost of sales   . . . . . . . . . . . . . . . . . . . . . . . . . . . .       19,284         23,178
      Administrative and selling expenses   . . . . . . . . . . . . . . . . .        2,269          2,397
      Interest    . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          279            286
                                                                                  --------       --------
                                                                                    21,832         25,861
                                                                                  --------       --------
          Income from textile products operations . . . . . . . . . . . . . .          465          1,118
</TABLE>





                                     Page 7
<PAGE>   8
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                     THREE MONTHS ENDED
                                                                                          JUNE 30,        
                                                                                   ----------------------
                                                                                    1998            1997   
                                                                                   -------        -------
<S>                                                                               <C>             <C>
OPERATING SUBSIDIARIES (CONTINUED)
   HOTELS
      Sales   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      $ 5,348        $ 5,579

      Operating expenses  . . . . . . . . . . . . . . . . . . . . . . . . . .        4,555          4,501
      Depreciation and amortization   . . . . . . . . . . . . . . . . . . . .          669            684
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          249            368
                                                                                   -------        -------
                                                                                     5,473          5,553
                                                                                   -------        -------
          Income (loss) from hotel operations . . . . . . . . . . . . . . . .         (125)            26
                                                                                   -------        -------

          Income from operating subsidiaries  . . . . . . . . . . . . . . . .          340          1,144

ASSOCIATED COMPANY
      Income from investment in ShowBiz   . . . . . . . . . . . . . . . . . .           --             89

      Interest (recovery)   . . . . . . . . . . . . . . . . . . . . . . . . .           --         (1,256)
                                                                                   -------        ------- 

          Income from associated company  . . . . . . . . . . . . . . . . . .           --          1,345

OTHER
      Litigation settlement   . . . . . . . . . . . . . . . . . . . . . . . .        1,025             --
      Fee income  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          138            179
      Interest on short-term investments and other income   . . . . . . . . .           73            382
                                                                                   -------        -------
                                                                                     1,236            561

      Administrative expenses   . . . . . . . . . . . . . . . . . . . . . . .          795            737
      Interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          220          1,114
                                                                                   -------        -------
                                                                                     1,015          1,851
                                                                                   -------        -------

          Other income (loss), net  . . . . . . . . . . . . . . . . . . . . .          221         (1,290)
                                                                                   -------        ------- 

      Income before income taxes and extraordinary gain   . . . . . . . . . .        2,017          2,475
      Income taxes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          112            131
                                                                                   -------        -------

      Income before extraordinary gain  . . . . . . . . . . . . . . . . . . .        1,905          2,344
      Extraordinary gain from extinguishment of debt  . . . . . . . . . . . .           --            877
                                                                                   -------        -------

NET INCOME  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      $ 1,905        $ 3,221
                                                                                   =======        =======

PER COMMON SHARE
   BASIC
      Income before extraordinary gain  . . . . . . . . . . . . . . . . . . .      $  1.48        $  1.48
      Extraordinary gain from extinguishment of debt  . . . . . . . . . . . .           --           0.57
                                                                                   -------        -------
          Net income  . . . . . . . . . . . . . . . . . . . . . . . . . . . .      $  1.48        $  2.05
                                                                                   =======        =======
   ASSUMING DILUTION
      Income before extraordinary gain  . . . . . . . . . . . . . . . . . . .      $  1.42        $  1.45
      Extraordinary gain from extinguishment of debt  . . . . . . . . . . . .           --           0.56
                                                                                   -------        -------
          Net income  . . . . . . . . . . . . . . . . . . . . . . . . . . . .      $  1.42        $  2.01
                                                                                   -------        -------
</TABLE>





                                     Page 8
<PAGE>   9
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                                      SIX MONTHS ENDED
                                                                                          JUNE 30,        
                                                                                 -------------------------
                                                                                   1998              1997   
                                                                                 -------          --------
<S>                                                                              <C>              <C>
CASH FLOWS FROM OPERATING ACTIVITIES
   Net income   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    $ 2,249          $ 11,602
                                                                                                          
   Adjustments to reconcile net income to net cash provided
      by operating activities:
      Depreciation, depletion and amortization  . . . . . . . . . . . . . . .      3,088             2,945
      Undistributed income from HEP   . . . . . . . . . . . . . . . . . . . .     (1,378)           (1,762)
      Distributions from HEP  . . . . . . . . . . . . . . . . . . . . . . . .        984               841
      Equity in net (income) of HRP   . . . . . . . . . . . . . . . . . . . .       (366)             (406)
      Amortization of deferred gain from debenture exchange   . . . . . . . .       (269)             (297)
      Extraordinary gain from extinguishment of debt  . . . . . . . . . . . .       (107)             (877)
      Equity in net (income) of  ShowBiz  . . . . . . . . . . . . . . . . . .         --            (1,139)
      Gain from sale of investment in ShowBiz   . . . . . . . . . . . . . . .         --           (18,277)
      Net change in deferred tax asset  . . . . . . . . . . . . . . . . . . .         --             8,960
      Payment of ShowBiz Participation Amount   . . . . . . . . . . . . . . .         --            (1,256)
      Net change in accrued interest on 13.5% Debentures  . . . . . . . . . .         --               762
      Net change in textile products assets and liabilities   . . . . . . . .      1,067            (4,624)
      Net change in other assets and liabilities  . . . . . . . . . . . . . .       (628)            1,964
      Net change in energy assets and liabilities   . . . . . . . . . . . . .        339               156
                                                                                 -------          --------

          Net cash provided by (used in) operating activities . . . . . . . .      4,979            (1,408)

CASH FLOWS FROM INVESTING ACTIVITIES
   Capital expenditures for hotels  . . . . . . . . . . . . . . . . . . . . .       (997)             (613)
   Investments in textile products property and equipment   . . . . . . . . .       (299)             (497)
   Investment in HEP by general partner   . . . . . . . . . . . . . . . . . .       (171)               --
   Net change in restricted cash for investing activities   . . . . . . . . .       (158)             (320)
   Investments in energy property and equipment   . . . . . . . . . . . . . .       (131)              (44)
   Net proceeds from sale of investment in ShowBiz  . . . . . . . . . . . . .         --            40,323
   Purchase of minority shares of HEC   . . . . . . . . . . . . . . . . . . .         --              (648)
                                                                                 -------          -------- 

          Net cash provided by (used in) investing activities . . . . . . . .     (1,756)           38,201

CASH FLOWS FROM FINANCING ACTIVITIES
   Repayment of bank borrowings and loans payable   . . . . . . . . . . . . .     (2,577)          (12,596)
   Repurchase of 7% Debentures  . . . . . . . . . . . . . . . . . . . . . . .     (2,146)               --
   Purchase of common stock for treasury  . . . . . . . . . . . . . . . . . .       (250)           (8,373)
   Payment of preferred stock dividends   . . . . . . . . . . . . . . . . . .        (50)              (50)
   Repurchase of 13.5% Debentures   . . . . . . . . . . . . . . . . . . . . .         --           (12,875)
   Proceeds from bank borrowings and loans payable  . . . . . . . . . . . . .         --             4,100
                                                                                 -------          --------

          Net cash used in financing activities . . . . . . . . . . . . . . .     (5,023)          (29,794)
                                                                                 -------          -------- 

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS  . . . . . . . . . . . .     (1,800)            6,999

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD  . . . . . . . . . . . . . . .      4,737             7,495
                                                                                 -------          --------

CASH AND CASH EQUIVALENTS, END OF PERIOD  . . . . . . . . . . . . . . . . . .    $ 2,937          $ 14,494
                                                                                 =======          ========
</TABLE>





                                     Page 9
<PAGE>   10
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

   1.    INTERIM CONSOLIDATED FINANCIAL STATEMENTS AND ACCOUNTING POLICIES

         Interim Consolidated Financial Statements.  The interim consolidated
    financial statements of The Hallwood Group Incorporated (the "Company")
    have been prepared in accordance with the instructions to Form 10-Q and do
    not include all of the information and disclosures required by generally
    accepted accounting principles, although, in the opinion of management, all
    adjustments considered necessary for a fair presentation have been
    included.  These 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, 1997.

         Accounting Policies.  The Company has adopted Statement of Financial
    Accounting Standards No. 130 - Reporting Comprehensive Income, effective
    January 1, 1998.  The Company had no items of comprehensive income for the
    periods presented herein.

            In June 1998, SFAS No. 133 - Accounting for Derivative Instruments
    and Hedging Activities was issued, which requires companies to recognize
    all derivatives as either assets or liabilities in the balance sheet and
    measure those instruments at fair value.  The changes in the fair value of
    a derivative depends on the intended use of the derivative.  The Company
    currently has hedging contracts in its energy segments as related to oil
    and gas activities.  The statement is effective for all fiscal quarters for
    fiscal years beginning after June 15, 1999.  The Company has not fully
    assessed the impact of the statement.

2.  INVESTMENTS IN REAL ESTATE AFFILIATE AND ASSOCIATED COMPANY (DOLLAR AMOUNTS
    IN THOUSANDS):

<TABLE>
<CAPTION>
                                                                                                         
                                                  AS OF JUNE 30, 1998             AMOUNT AT          INCOME FROM INVESTMENTS
                                               -------------------------       WHICH CARRIED AT      FOR THE SIX MONTHS ENDED 
                                                                 COST OR    -----------------------         JUNE 30,       
      BUSINESS SEGMENTS AND                     NUMBER OF       ASCRIBED    JUNE 30,    DECEMBER 31,  ---------------------
     DESCRIPTION OF INVESTMENT                   UNITS           VALUE       1998          1997         1998         1997    
     -------------------------                 ---------        --------    --------     ---------    --------     --------
    <S>                                         <C>             <C>         <C>          <C>         <C>          <C>
    REAL ESTATE AFFILIATE
       HALLWOOD REALTY PARTNERS, L.P. (A)
       - General partner interest   . . . . .         --        $  8,650    $  4,110     $   4,435    $     11     $     13
       - Limited partner interest   . . . . .    413,040           5,381       3,117         2,762         355          393
                                                                --------    --------     ---------    --------     --------
                                                                                                                           
           Totals . . . . . . . . . . . . . .                   $ 14,031    $  7,227     $   7,197    $    366     $    406
                                                                ========    ========     =========    ========     ========

    ASSOCIATED COMPANY
       SHOWBIZ PIZZA TIME, INC. (B)
       - Common stock
           Equity in earnings . . . . . . . .                                                                      $  1,139
           Gain on sale of shares . . . . . .                                                                        18,277
                                                                                                                   --------
           Totals . . . . . . . . . . . . . .                                                                      $ 19,416
                                                                                                                   ========
</TABLE>

         (A) At June 30, 1998, Hallwood Realty Corporation ("HRC"), a wholly
             owned subsidiary of the Company, owned a 1% general partner
             interest and the Company owned a 25% limited partner interest in
             its Hallwood Realty Partners, L.P. ("HRP") affiliate.  The Company
             accounts for its investment in HRP using the equity method of
             accounting.  In addition to recording its share of net income
             (loss), the Company also records its pro rata share of any partner
             capital transactions reported by HRP.  The carrying value of the
             Company's investment in HRP includes such non-cash adjustments for
             its pro-rata share of HRP's capital transactions with
             corresponding adjustments to additional paid-in capital.  The
             cumulative amount of such adjustments from the original date of
             investment through June 30, 1998, resulted in a $49,000 decrease
             in the carrying value of the HRP investment.

             The carrying value of the Company's general partner interest
             includes the value of intangible rights to provide asset
             management and property management services.  The Company
             amortizes that portion of the general partner interest ascribed to
             the management rights.  For the six months ended June 30, 1998 and
             1997 such amortization was $336,000 in each period.





                                    Page 10
<PAGE>   11
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JUNE 30, 1998
                                  (UNAUDITED)

             As discussed in Note 4, the Company has pledged 89,269 limited
             partner units to collateralize a promissory note in the principal
             amount of $500,000 and issued a limited negative pledge on all of
             the HRP units, including the 89,269 pledged units, to secure the
             energy term loan.

             The quoted market price and the Company's carrying value per
             limited partner unit (Quotron symbol HRY) at June 30, 1998 were
             $70.00 and $7.55, respectively.  The general partner interest is
             not publicly traded.

         (B) The Company accounted for its investment in ShowBiz Pizza Time,
             Inc. ("ShowBiz") using the equity method of accounting.  For the
             1997 six month period the equity income was $1,139,000.

             In March 1997, the Company completed the sale of its entire
             2,632,983 shares of  ShowBiz common stock at $15.68 per share, net
             of underwriting commissions.  A portion of the proceeds from the
             sale were used to repay a $7,000,000 line of credit and a
             $4,000,000 promissory note.  The Company reported a gain of
             $18,277,000 from the transaction.

3.  LITIGATION, CONTINGENCIES AND COMMITMENTS

         Reference is made to Note 17 to the consolidated financial statements
    contained in Form 10-K for the year ended December 31, 1997.  There has
    been no significant change since that time.

4.  LOANS PAYABLE

         Loans payable at the balance sheet dates are detailed below by
business segment (in thousands):

<TABLE>
<CAPTION>
                                                                         JUNE 30,      DECEMBER 31,
                                                                          1998            1997       
                                                                       ----------       ---------       
         <S>                                                           <C>              <C>
         Real Estate
           Promissory note, 8%, due March 1998  . . . . . . . . . . .  $      500       $     500

         Energy
           Term loan, libor + 3.5%, due May 2000  . . . . . . . . . .       3,067           3,867

         Textile Products
           Revolving credit facility, prime + .25%, due January 2000       12,100          13,800

         Hotels
           Term loan, 7.86% fixed, due January 2008 . . . . . . . . .       6,706           6,750
           Term loan, 8.20% fixed, due November 2007  . . . . . . . .       5,236           5,269
                                                                       ----------       ---------       
                                                                           11,942          12,019
                                                                       ----------       ---------       
              Total . . . . . . . . . . . . . . . . . . . . . . . . .  $   27,609       $  30,186
                                                                       ==========       =========       
</TABLE>

         Further information by business segment is provided below:

    Real Estate

         Promissory note.  In connection with the settlement of an obligation
    related to the Company's Integra Hotels, Inc. subsidiary, the Company
    issued a four-year, $500,000 promissory note due March 8, 1998.  The note
    is secured by a pledge of 89,269 HRP limited partner units.  The settlement
    agreement also provided that the noteholder had the right to receive an
    additional payment in an amount equal to 25% of the increase in the value
    of the HRP units over the base amount of $8.44 per unit, but in no event
    more than an additional $500,000





                                    Page 11
<PAGE>   12
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JUNE 30, 1998
                                  (UNAUDITED)

    (the "HRP Participation Amount").  The Company accrued the full amount of
    $500,000 as a charge to interest expense, of which $50,000 and $60,000 were
    recorded in the six months ended June 30, 1998 and 1997, respectively.

         The Company tendered full payment, including the HRP Participation
    Amount totaling $1,000,000, in March 1998, although it reserved its rights
    to litigate the validity of an earlier tender that was rejected by the
    noteholder.  The noteholder refused acceptance of the tendered payment and
    returned it to the Company and instituted litigation in the State of
    Delaware.  The litigation is currently in the discovery phase and a trial
    date has been scheduled for September 1998.

    Energy

         Term loan.  In November 1997, the Company's HEPGP Ltd. partnership
    ("HEPGP") amended, restated and increased its term loan to $4,000,000 from
    the First Union Bank of North Carolina.  The term loan is collateralized by
    all of the Company's HEP limited partner units and its investment in HEPGP
    and Hallwood GP, Inc.  HEPGP has also pledged its direct interests in
    certain oil and gas properties.  Other significant terms include: (i)
    maturity date of May 15, 2000; (ii) monthly principal payments of $133,000,
    plus interest; (iii) interest rate of libor plus 3.5% (9.16% at June 30,
    1998); (iv) a limited negative pledge relating to the Company's HRP limited
    partner units; and (v) restrictions on the declaration of distributions or
    redemptions of partnership interests.  The outstanding balance at June 30,
    1998 was $3,067,000.

         Included in the consolidated balance sheets are the Company's share of
    the long-term obligations of its affiliated entity, Hallwood Energy
    Partners, L.P. ("HEP") in the amount of $4,787,000 and $4,731,000 at June
    30, 1998 and December 31, 1997, respectively.

    Textile Products

         Revolving credit facility.  In January 1997, the Company's Brookwood
    subsidiary entered into a new revolving credit facility in an amount of up
    to $14,000,000 ($15,000,000 between April and June 1997) with The Bank of
    New York ("BNY").  The facility was amended on April 30, 1998 to
    temporarily increase the facility to $17,500,000 for the period between
    March and August 1998, and to permanently increase the amount to
    $15,000,000 thereafter.  Borrowings are collateralized by accounts
    receivable, inventory imported under trade letters of credit, certain
    finished goods inventory, the machinery and equipment of Brookwood's
    subsidiaries and all of the issued and outstanding capital stock of
    Brookwood and its subsidiaries.  The BNY facility expires on January 7,
    2000 and bears interest, at Brookwood's option, at one-quarter percent over
    prime (8.75% at June 30, 1998) or libor plus 2.25%.  Availability for
    direct borrowings and letter of credit obligations under the facility are
    limited to the lesser of the facility or the formula borrowing base, as
    defined in the agreement.  The facility contains covenants, which include
    maintenance of certain financial ratios, restrictions on dividends and
    repayment of debt or cash transfers to the Company.  The outstanding
    balance at June 30, 1998 was $12,100,000.

    Hotels

         Term loan.  In December 1997, the Company's Brock Suite Greenville,
    Inc. subsidiary entered into a new $6,750,000 mortgage loan, collateralized
    by the Residence Inn hotel located in Greenville, South Carolina, which
    replaced the former term loan.  Significant terms include: (i) fixed
    interest rate of 7.86%; (ii) monthly loan payments of $51,473 based upon
    25-year amortization schedule with a maturity date of January 2008; (iii)
    prepayment permitted after December 1999, subject to yield maintenance
    provisions and (iv) various other financial and non- financial covenants.
    The outstanding balance at June 30, 1998 was $6,706,000.

         Term loan.  In October 1997, the Company's Brock Suite Tulsa, Inc.
    subsidiary entered into a new $5,280,000 mortgage loan collateralized by
    the Residence Inn hotel in Tulsa, Oklahoma, which replaced the





                                    Page 12
<PAGE>   13
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JUNE 30, 1998
                                  (UNAUDITED)

    former term loan.  Significant terms include: (i) fixed interest rate of
    8.20%; (ii) monthly loan payments of $41,454, based upon 25-year
    amortization schedule, with a maturity date of November 2007; (iii)
    prepayment permitted after October 2001, subject to yield maintenance
    provisions and; (iv) various other financial and non-financial covenants.
    The outstanding balance at June 30, 1998 was $5,236,000.

5.  7% COLLATERALIZED SENIOR SUBORDINATED DEBENTURES

         In March 1993, the Company completed an exchange offer whereby
    $27,481,000 of its former 13.5% Debentures were exchanged for a new issue
    of 7% Collateralized Senior Subordinated Debentures due July 31, 2000 (the"
    7% Debentures"), and purchased for cash $14,538,000 of its 13.5% Debentures
    at 80% of face value.  Interest is payable quarterly in arrears, in cash,
    and the 7% Debentures are secured by a pledge of all of the capital stock
    of the Brookwood and Hallwood Hotels, Inc. subsidiaries.  The common and
    preferred stock of Brookwood are subject to a prior pledge in favor of BNY.

         Between 1994 and 1997, the Company repurchased 7% Debentures having a
    principal value of $4,673,000.  These repurchases satisfied the Company's
    obligation to retire 10% of the original issue ($2,748,000) prior to March
    1996, and partially satisfied the Company's obligation to retire an
    additional 15% of the original issue ($4,122,000) prior to March 1998.  In
    January 1998, the Company repurchased 7% Debentures with a face amount of
    $2,253,000 for $2,146,000, to fully satisfy the balance of the sinking fund
    requirement contained in the indenture.  The repurchase resulted in an
    extraordinary gain from debt extinguishment of $107,000 in the 1998 first
    quarter.

         Balance sheet amounts are detailed below (in thousands):

<TABLE>
<CAPTION>
                                                                             JUNE 30,       DECEMBER 31,
                               DESCRIPTION                                     1998            1997     
               ------------------------------------------                    --------       ------------                          
           <S>                                                               <C>              <C>
             7% Debentures (face amount)  . . . . . . . . . . . . . . . .    $ 20,555         $ 22,808
             Unrecognized gain from purchase and exchange, net of                               
                $3,005 and $2,736 accumulated amortization,                                     
                respectively  . . . . . . . . . . . . . . . . . . . . . .       1,215            1,484
                                                                             --------         --------   
                                                                                                
                   Totals   . . . . . . . . . . . . . . . . . . . . . . .    $ 21,770         $ 24,292
                                                                             ========         ========   
</TABLE>

         Exchange Offer.  On June 17, 1998, the Company announced a
    commission-free exchange offer (the "Exchange Offer") to all holders of its
    7% Debentures.  The Company offered to exchange the 7% Debentures for a new
    issue of 8.5% Collateralized Subordinated Debentures due July 31, 2005 in
    the ratio of $100 principal amount of 8.5% Debentures for each $100
    principal amount of 7% Debentures tendered for exchange.  The original
    expiration date for the Exchange Offer was Friday July 31, 1998.  On that
    date, the Company announced that it has extended the expiration date to
    August 28, 1998, and increased the interest rate from 8.5% to 10.0% for the
    new issue of Collateralized Subordinated Debentures due July 31, 2005  (the
    "10.0% Debentures").  Tendering debenture holders will be entitled to
    receive accrued interest from July 31, 1998, the date of the last interest
    payment.

         The 10.0% Debentures will be secured by a first and senior lien on the
    capital stock of the Company's Brock Suites Hotel, Inc. subsidiary and by a
    subordinate and junior lien on the capital stock of the Brookwood and
    Hallwood Hotels, Inc. subsidiaries which are pledged to secure the 7%
    Debentures.

         Terms and conditions of the Exchange Offer are described in an
    Exchange Offer Circular dated June 22, 1998, and a supplemental
    modification letter dated July 31, 1998, both of which were mailed to all
    holders of the 7% Debentures.





                                    Page 13
<PAGE>   14
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JUNE 30, 1998
                                  (UNAUDITED)

6.  INCOME TAXES

         The following is a summary of income tax expense (in thousands):

<TABLE>
<CAPTION>
                                                   THREE MONTHS ENDED                 SIX MONTHS ENDED
                                                        JUNE 30,                          JUNE 30,      
                                                  --------------------              --------------------
                                                  1998           1997               1998          1997  
                                                  -----          -----              -----       --------
             <S>                                  <C>            <C>                <C>         <C>
             Federal
                Current . . . . . . . . . . . .   $  20          $  25              $  30       $    525
                Deferred  . . . . . . . . . . .      --             --                 --          8,960
                                                  -----          -----              -----       --------
                   Sub-total  . . . . . . . . .      20             25                 30          9,485

             State    . . . . . . . . . . . . .      92            106                177            241
                                                  -----          -----              -----       --------
                   Total  . . . . . . . . . . .   $ 112          $ 131              $ 207       $  9,726
                                                  =====          =====              =====       ========
</TABLE>

         As a result of the substantial tax gain from the March 1997 sale of
    ShowBiz, the Company recorded a related non-cash deferred federal tax
    charge of $8,960,000 in the 1997 first quarter, which reflected the
    realization of tax benefits from the utilization of the Company's tax net
    operating loss carryforwards ("NOLs") and a current federal tax charge of
    $500,000  for alternative minimum tax.

         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.

         The amount of the deferred tax asset (net of valuation allowance) was
    $2,040,000 at June 30, 1998.  The deferred tax asset arises principally
    from the anticipated utilization of the Company's NOLs and tax credits from
    the implementation of various tax planning strategies.

7.  SUPPLEMENTAL DISCLOSURES TO THE CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                             SIX MONTHS ENDED
                                                                                 JUNE 30,      
                                                                           ------------------- 
                        DESCRIPTION                                          1998        1997  
           -----------------------------------------                       ------        ----- 
         <S>                                                               <C>           <C>
         Supplemental schedule of noncash investing and financing 
           activities:

            Issuance of treasury stock in exchange for
            common shares of ShowBiz:
               Investment in ShowBiz  . . . . . . . . . . . . . . . . . .  $    --       $3,820
                                                                                               
               Reduction of additional paid-in capital  . . . . . . . . .       --        2,626
                                                                           -------       ------
               Reduction in treasury stock  . . . . . . . . . . . . . . .       --        6,446
            Repayment of note payable from funds held in
               restricted cash  . . . . . . . . . . . . . . . . . . . . .       --          375
            Recording of proportionate share of stockholders'
               equity transaction of equity investments . . . . . . . . .       --          143

         Supplemental disclosures of cash payments:

            Interest paid . . . . . . . . . . . . . . . . . . . . . . . .  $ 1,995       $3,030
            Income taxes paid . . . . . . . . . . . . . . . . . . . . . .      371          404
</TABLE>





                                    Page 14
<PAGE>   15
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JUNE 30, 1998
                                  (UNAUDITED)

8.  COMPUTATION OF EARNINGS PER SHARE

         The following table reconciles the Company's net income to net income
    available to common stockholders, and the number of equivalent common
    shares used in the calculation of net income for the basic and assumed
    dilution methods (in thousands, except per share amounts):
<TABLE>
<CAPTION>
                                                                 THREE MONTHS ENDED         SIX MONTHS ENDED
                                                                      JUNE 30,                  JUNE 30,     
                                                                ---------------------      ------------------
                        DESCRIPTION                              1998          1997          1998       1997  
           -----------------------------------------           --------      --------      --------   --------
         <S>                                                    <C>            <C>          <C>      <C>
         NET INCOME
         Net income, as reported  . . . . . . . . . . . . . .   $1,905         $3,221       $2,249    $11,602
         Less: Dividends on preferred stock . . . . . . . . .       50             50           50         50
                                                                ------         ------       ------    -------
         Net income available to common stockholders  . . . .   $1,855         $3,171       $2,199    $11,552
                                                                ======         ======       ======    =======


         AVERAGE SHARES OUTSTANDING
         Outstanding shares - basic . . . . . . . . . . . . .    1,255          1,546        1,255      1,553
         Stock options  . . . . . . . . . . . . . . . . . . .       55             33           53         30
                                                                ------         ------       ------    -------
         Outstanding shares - assuming dilution . . . . . . .    1,310          1,579        1,308      1,583
                                                                ======         ======       ======    =======

         NET INCOME PER COMMON SHARE
         Basic  . . . . . . . . . . . . . . . . . . . . . . .    $1.48          $2.05        $1.75      $7.44
         Assuming dilution  . . . . . . . . . . . . . . . . .    $1.42          $2.01        $1.68      $7.30
</TABLE>

9.  SUBSEQUENT EVENT

          In July 1998, the Company purchased the owner's rental contracts,
    real estate and certain other assets for $2.1    million at The Enclave
    Suites resort condominium hotel located in Orlando, Florida.





                                    Page 15
<PAGE>   16
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS


                             RESULTS OF OPERATIONS

         The Company reported net income of $1,905,000 for the second quarter
    ended June 30, 1998, compared to  net income of $3,221,000 in the  1997
    period.  The six month net income of $2,249,000 compared to net income of
    $11,602,000 in the 1997 period.  Total revenue for the 1998 second quarter
    was $32,025,000, compared to $36,258,000 in the prior-year period.  For the
    six months, revenue was $63,125,000, compared to $88,073,000 in the
    prior-year period.  The 1997 six months results included a gain of
    $18,277,000 from the sale of the Company's investment in ShowBiz, partially
    offset by a related tax charge of $9,485,000.

         Following is an analysis of the results of operations by asset
    management, operating subsidiaries and associated company divisions; and by
    the real estate, energy, textile products, hotels and restaurant business
    segments within those divisions.

         Asset Management.  The business segments of the Company's asset
    management division consist of real estate and energy.

    REAL ESTATE.

         Revenue.  Fee income of $1,393,000 for the quarter ended June 30, 1998
    decreased by $152,000, or 10%, from $1,545,000 in the prior-year period.
    Fee income of $2,635,000 for the six months increased by $117,000 from
    $2,518,000 for the similar period a year ago.  Fees are derived from asset
    management, property management, leasing and construction supervision
    services provided to its Hallwood Realty Partners, L.P. affiliate, a real
    estate master limited partnership ("HRP") and various third parties.  The
    fluctuations are due primarily to the timing of leasing fees earned from
    third party owners, partially offset by a decline in fees for construction
    supervision services.

         The equity income from investments in HRP represents the Company's
    recognition of its pro rata share of the income reported by HRP and
    amortization of negative goodwill.  For the 1998 second quarter, the
    Company reported income of $428,000 compared to income of $316,000 in the
    period a year ago.  The comparative six month amounts were income of
    $366,000 in 1998 and $406,000 in 1997.  The six month decline resulted
    principally from HRP's recognition of an extraordinary loss from early debt
    extinguishment in the 1998 first quarter.

         Expenses.  Administrative expenses of $460,000 and $1,015,000 , in the
    1998 second quarter and six month periods, decreased from $579,000 and
    $1,114,000 in the comparable year-ago periods, due to lower leasing
    commissions paid in connection with the reduced leasing fees earned from
    third party owners.

         Amortization expense of $168,000 for the second quarter and $336,000
    for the six months in both the 1998 and 1997 periods relate to HRC's
    general partner investment in HRP to the extent allocated to management
    rights.

         Interest expense decreased to $-0- from $40,000 in the 1998 second
    quarter and to $58,000 from $80,000 in the six month period, due to reduced
    charges in the 1998 periods for the HRP Participation Amount discussed in
    Note 4 on the related $500,000 promissory note pending the outcome of
    litigation.

    ENERGY.

         Revenue.  After the Company's successful completion of the tender
    offer for the minority shares of Hallwood Energy Corporation ("HEC") and
    the subsequent merger of HEC in November 1996, it effectively acquired
    ownership of the assets formerly held by HEC.  Following the merger,
    certain HEC assets were transferred to two wholly owned entities.  The two
    entities, in addition to other energy assets which remain with the Company,
    constitute the Company's investment in the energy industry.  The general
    partner interest in HEP entitles the general partner to interests in HEP's
    properties ranging from 2% to 25%.  The Company also owns an approximate
    6.5% interest in HEP limited partner units.  The Company and its energy
    subsidiaries account for their ownership of HEP using the proportionate
    consolidation method of accounting, whereby they record their proportionate
    share of HEP's revenues and expenses, current assets, current





                                    Page 16
<PAGE>   17
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS


    liabilities, noncurrent assets, long-term obligations and fixed assets.
    HEP owns approximately 46% of its affiliate, Hallwood Consolidated
    Resources Corporation ("HCRC"), which HEP accounts for under the equity
    method.

         Gas revenue for the 1998 second quarter increased $334,000, or 52%, to
    $982,000 from $648,000.  For the six months, gas revenue increased
    $135,000, or 8%, to $1,845,000 from $1,710,000.  The increase in gas
    revenue for the six months was due primarily to an increase in production
    to 879,000 mcf from 703,000 mcf, partially offset by a decrease in the
    average gas price to $2.10 from $2.43 per mcf.  Oil revenue for the 1998
    second quarter decreased $78,000, or 20%, to $317,000 from $395,000.  For
    the six months, oil revenue declined by $277,000, or 27%, to $743,000 from
    $1,020,000.  The decrease for the six months was attributable to a decrease
    in the average price per barrel to $13.27 from $20.40, partially offset by
    an increase in production to 56,000 barrels from 50,000 barrels.  The
    increase in oil and gas production is primarily due to the shut-in of two
    wells in Louisiana while workover procedures were performed during the
    second quarter of 1997.

         Other income consists primarily of acquisition fee and interest
    income, as well as a share of HEP's interest income, facilities income from
    two gathering systems in New Mexico, pipeline revenue, equity in income of
    affiliates and miscellaneous income or expense.  The decreases in other
    income to $24,000 for the 1998 quarter from $146,000 in the 1997 period and
    to $74,000 for the 1998 six month period from $224,000 in the 1997 period
    are primarily due to a decrease in HEP's equity in earnings of affiliate
    due to a property impairment taken by HEP's affiliate during the 1998
    second quarter.

         Expenses.  Operating expenses increased by $69,000 to $401,000 for the
    1998 second quarter from $332,000 in the prior-year quarter and increased
    by $140,000 to $800,000 for the six months from $660,000 as a result of
    increased production taxes resulting from the increased production
    described above.

         Depreciation, depletion and amortization decreased to $309,000 for the
    1998 second quarter and increased to $686,000 for the six months compared
    to $318,000 and $627,000 in the year-ago periods.  The increase for the six
    month period is attributable to higher depletion in 1998 due to the
    increase in production.

         Administrative expenses decreased by $12,000 for the 1998 second
    quarter to $221,000 from $233,000 in the 1997 quarter and decreased by
    $62,000 to $446,000 for the 1998 six month period from $508,000 due to a
    decrease in allocated internal overhead.

         Interest expense increased by $25,000 to $129,000 for the 1998 second
    quarter compared to $104,000 in 1997 and increased by $51,000 to $275,000
    for the 1998 six month period, compared to $224,000 in 1997, due to an
    increase in the Company's term loan in November 1997 and an increase in the
    pro rata share of HEP's interest expense due to HEP's higher outstanding
    debt in 1998.

         Operating Subsidiaries.  The business segments of the Company's
    operating subsidiaries consist of textile products and hotels.

TEXTILE PRODUCTS.

         Revenue.  Sales  of $22,297,000 decreased $4,682,000, or 17%, in the
    1998 second quarter, compared to $26,979,000 in the 1997 quarter.  The
    comparative six month sales decreased $4,872,000, or 10%, to $45,612,000
    from $50,484,000 in 1997.  Sales of the distribution businesses were lower
    in the 1998 periods than in 1997, due to decreased demand for textile
    products in consumer markets, which was partially offset by increased sales
    of industrial products.  This appears to be the result of a high level of
    U.S. consumer spending on durable goods versus nondurable, unusual weather
    patterns affecting outerwear sales and availability of lower priced Asian
    imports.  The decrease in sales at the processing plants was less than 1%.

         Expenses.  Cost of sales of $19,284,000 decreased $3,894,000, or 17%,
    from $23,178,000 in the 1998 second quarter and decreased $4,106,000, or 9%,
    to $39,442,000 from $43,548,000 for the six months.  The decrease in cost
    of sales was





                                    Page 17
<PAGE>   18
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS


    principally the result of the decrease of sales revenue.  The lower gross
    profit margin for the 1998 second quarter (13.5% versus 14.1%) and the
    six-month periods (13.5% versus 13.7%) resulted from lower gross profit
    margin in distribution businesses due to competitive market pressures
    experienced in 1998.

          Administrative and selling expenses of $2,269,000 decreased by
    $128,000 in the 1998 second quarter from $2,397,000 for the comparable 1997
    period, and decreased $126,000 for the six-month period to $4,532,000 from
    $4,658,000 for the comparable 1997 period.

         Interest expense decreased by $7,000 to $279,000 for the 1998 second
    quarter from $286,000 in 1997, and increased by $20,000 for the six months
    to $548,000 from $528,000 due to fluctuating average borrowings during the
    periods.

    HOTELS

         Revenue.  Sales of $5,348,000 in the 1998 second quarter decreased by
    $231,000, or 4% from the year-ago amount of $5,579,000.  The 1998 six-month
    hotel sales of $10,346,000 decreased by $1,090,000, or 10%, compared to
    $11,436,000 for the 1997 period.  The Longboat Key Holiday Inn revenues for
    the six months declined by $836,000, as a result of an extensive renovation
    project, which began in October 1997 and was completed in April 1998, and
    adverse weather conditions.  For the remaining hotel properties, the
    average daily rate declined 3.2% and the average occupancy level was
    unchanged in the 1998 six months compared to the prior-year period.

         Expenses.  Operating expenses of $4,555,000 for the 1998 second
    quarter were up $54,000 from $4,501,000 in 1997.  The 1998 six month hotel
    operating expenses decreased by $49,000 to $8,980,000, compared to
    $9,029,000 for the 1997 period.  The reduction for the six months was
    attributable to minor decreases at the various properties, partially offset
    by an increase of $57,000 at the Residence Inn hotel in Greenville, South
    Carolina.

         Depreciation and amortization expense decreased by $15,000 to $669,000
    for the 1998 second quarter from $684,000 in the prior-year period.
    Depreciation and amortization for the 1998 and 1997 six month periods were
    $1,338,000 and $1,374,000, respectively.  The decrease is attributable to
    the full amortization of the leasehold interest for the Oklahoma City
    Embassy Suite in June 1997, offset by additional depreciation from recent
    capital expenditures at the remaining properties.

         Interest expense decreased by $119,000 to $249,000 for the 1998 second
    quarter from $368,000 in 1997 and decreased by $231,000 to $501,000 for the
    six month period from $732,000, principally due to the refinancing of the
    mortgage loans in the 1997 fourth quarter on the Residence Inn hotels in
    Tulsa, Oklahoma and Greenville, South Carolina at more favorable interest
    rates.

    ASSOCIATED COMPANY

         Revenue.  The 1997 six month period includes income of $1,139,000 from
    the Company's pro-rata share of ShowBiz results using the equity method of
    accounting prior to the sale.  In March 1997 the Company completed the sale
    of its entire 2,632,983 ShowBiz shares at $15.68 per share, net of
    underwriting commissions, and reported a gain of $18,277,000 from the
    transaction.  See Note 2.

         Expenses.  Interest recovery of $1,256,000 for the 1997 second quarter
    was primarily attributable to the settlement of litigation involving the
    ShowBiz Participation Amount with the Integra Unsecured Creditors Trust.
    The Company had recorded the potential amount of $1,675,000 for the ShowBiz
    Participation Amount provisions associated with the $4,000,000 promissory
    note in the 1997 first quarter, which was adjusted to the settlement amount
    in the 1997 second quarter.





                                    Page 18
<PAGE>   19
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS




    OTHER

         Revenue.  In May 1998, the Company favorably settled a 1996 litigation
    claim involving its former merchant banking activities for $1,025,000 in
    cash, which has been reported as income in the 1998 second quarter.  Fee
    income in the 1998 second quarter of $138,000 and $275,000 for the six
    months compares to the 1997 amounts of $179,000 and $285,000, respectively.
    The decreases are primarily due to a modification of a consulting agreement
    with one of the Company's affiliated companies.  Interest on short-term
    investments and other income decreased by $309,000 to $73,000 for the 1998
    second quarter and decreased by $370,000 to $204,000 for the 1998 six
    months from $382,000 and $574,000, respectively.  The decreases were
    primarily attributable to lower interest income earned on the Company's
    short-term investments, and lower rental income from the subleasing of
    executive office space formerly occupied by the Company's affiliated entity
    - Integra-A Hotel and Restaurant Company, which lease expired in May 1998.

         Expenses.  Administrative expenses of $795,000 for the 1998 second
    quarter increased by $58,000, or 8%, from the prior year amount of
    $737,000, and declined in the 1998 six month period by $17,000, or 1%, to
    $1,360,000, compared to the prior year amount of $1,377,000.  The 1998
    second quarter and six month expenses included a payment of $145,000 for
    the value of retiring unexercised stock options.

         Interest expense in the amount of $220,000 for the 1998 second quarter
    decreased by $894,000 from the prior year amount of $1,114,000 and
    decreased $1,761,000 for the six months to $459,000 from the prior year
    amount of $2,220,000.  The decreases were primarily due to the Company's
    repurchase of $12,875,000 of its 13.5% Debentures pursuant to a self-tender
    offer completed in June 1997 and the redemption of the remaining
    $14,287,000 balance of its outstanding 13.5% Debentures completed in
    December 1997.  Additionally, the Company repurchased 7% Debentures with a
    face amount of $2,253,000 in January 1998, to satisfy the balance of a
    sinking fund requirement contained in the indenture.  See Note 5.

         Income taxes.  Income taxes were $112,000 for the 1998 second quarter
    and $131,000 in the 1997 quarter.  The 1998 quarter included a $20,000
    federal current charge and $92,000 for state taxes compared to the 1997
    second quarter which included a $25,000 federal current charge and $106,000
    for state taxes.  The 1998 six month period included a $30,000 federal
    current charge and $177,000 for state taxes.  The 1997 six month period
    included an $8,960,000 non-cash federal deferred tax charge, a federal
    current charge of $525,000  for  alternative minimum tax (both charges
    primarily relating to the ShowBiz sale) and $241,000 for state taxes.  The
    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.  See Note 6.

         As of June 30, 1998, the Company had approximately $115,000,000 of tax
    net operating loss carryforwards ("NOLs") and temporary differences to
    reduce future federal income tax liability, including $42,944,000 of NOLs
    which expire in the 1998 calendar year.  Based upon the Company's
    expectations and available tax planning strategies, management has
    determined that taxable income will more likely than not be sufficient to
    utilize approximately $6,000,000 of the NOLs prior to their ultimate
    expiration in the year 2011.

         Management believes that the Company has certain tax planning
    strategies available, which include the potential sale of hotel properties
    and certain other assets, that could be implemented, if necessary, to
    supplement income from operations to fully realize the recorded tax
    benefits before their expiration.  Management has considered such
    strategies in reaching its conclusion that, more likely than not, taxable
    income will be sufficient to utilize a portion of the NOLs before
    expiration; however, future levels of operating income and taxable gains
    are dependent upon general economic conditions and other factors beyond the
    Company's control.  Accordingly, no assurance can be given that sufficient
    taxable income will be generated for utilization of the NOLs.  Management
    periodically re- evaluates its tax planning strategies based upon changes
    in facts and circumstances and, accordingly, considers potential
    adjustments to the valuation allowance of the deferred tax asset.  Although
    the use of such carryforwards could, under certain circumstances, be
    limited, the Company is presently unaware of the occurrence of any event
    which would result in the imposition of such limitations.





                                    Page 19
<PAGE>   20
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS


         Extraordinary gain from extinguishment of debt.  The Company
    recognized an extraordinary gain from debt extinguishment of $107,000 in
    the 1998 first quarter from the purchase of 7% Debentures having a face
    amount of $2,253,000 for a discounted amount of $2,146,000.  During the
    1997 second quarter, the Company recognized an extraordinary gain of
    $877,000, which was attributable to the partial repurchase of 13.5%
    Debentures pursuant to the self-tender offer completed in June 1997.





                                    Page 20
<PAGE>   21
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS


                        LIQUIDITY AND CAPITAL RESOURCES

         The Company's unrestricted cash and cash equivalents at June 30, 1998
    totaled $2,937,000.
 
         The Company's real estate segment generates funds  principally from
    its property management and leasing activities, without significant
    additional capital costs.  All of the HRP limited partnership units are
    subject to a limited negative pledge on the Company's energy term loan.  If
    the Company pledges designated HRP units, as defined, having a market value
    up to $2,000,000, the negative pledge can be released.

         The Company's energy segment generates funds from operating and
    financing activities.  Cash flow is subject to fluctuating oil and gas
    production and prices.  In accordance with the proportionate consolidation
    method of accounting, the Company reports its share of the long-term
    obligations of its HEP affiliate which was $4,787,000 at June 30, 1998.
    HEP's borrowings are secured by a first lien on approximately 80% in value
    of HEP's oil and gas properties.  HEP's unused borrowing capacity under the
    revolving credit agreement was $22,800,000 at June 30, 1998.  HEPGP
    amended, restated and increased its term loan to $4,000,000 in November
    1997 which had a balance of $3,067,000 at June 30, 1998.  The term loan
    contains a provision which prohibits HEPGP from making any distribution to
    the Company during the term of the loan which matures in May 2000.

         In February 1998, HEP closed its public offering of 1.8 million Class
    C units priced at $10.00 per unit.  Proceeds to HEP, net of underwriting
    discounts and expenses, were approximately $16,315,000.  HEP used
    $14,000,000 of the net proceeds to repay borrowings and applied the
    remaining amount towards the repayment of HEP's outstanding contract
    settlement obligation.

         Brookwood maintains a revolving line of credit facility with The Bank
    of New York, which is collateralized by accounts receivable, certain
    inventory and equipment.  At June 30, 1998, Brookwood had $3,708,000 of
    unused borrowing capacity on its line of credit.  In April 1998, the
    Company received a $500,000 cash dividend from Brookwood on its preferred
    stock and is expected to receive an additional $284,000 in September 1998.
    Future dividends will be paid as permitted by the revolver, which allows
    for dividends to be paid to the extent of 80% of cash flow after capital
    expenditures.

         The Company's hotel segment generates cash flow from operating five
    hotels (one Holiday Inn in Florida, one Embassy Suites and one Residence
    Inn in Oklahoma, and one Residence Inn each in Alabama and South Carolina).
    The sale of hotel properties may also provide a source of liquidity;
    however, sales transactions may be impacted by the inability of prospective
    purchasers to obtain equity capital or suitable financing.  The Company has
    recently renovated the Longboat Key Holiday Inn hotel with part of the
    financing provided by the owner, and has been informed by Marriott that
    substantial renovations will have to be made to each of the three Residence
    Inn hotels prior to the renewal of their franchise in January 2000.  In
    July 1998, the Company acquired the owner's rental contracts to manage a
    hotel condominium resort in Orlando, Florida, for which it will receive
    monthly management fees.

         Management believes that it will have sufficient funds for operations
    and to satisfy its obligations.

           Information Systems and the Year 2000.  As the year 2000 approaches,
    there are uncertainties concerning whether computer systems will properly
    recognize date-sensitive information when the year changes to 2000.
    Systems that do not properly recognize such information could generate
    erroneous data or fail.  The Company's primary software package has been
    developed and is continually updated by a third-party provider, who has
    provided assurances that timely updates will be made available to ensure
    full Year 2000 compliance of the software package.  The Company expects to
    receive the fully tested and updated software package in 1998 and
    anticipates that it will incur nominal costs associated with its software
    or hardware operating systems for this process.  Additionally, the Company
    is currently in the process of verifying that its affiliated entities,
    service providers and other external parties are addressing and resolving
    their Year 2000 compliance.  Failure by the Company, or its affiliates,
    vendors or customers, to complete Year 2000 compliance work in a timely
    manner could have a material adverse effect on the Company's operations.





                                    Page 21
<PAGE>   22
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                          PART II - OTHER INFORMATION

<TABLE>
<CAPTION>
Item
----
    <S>  <C>                                                                                            <C>
    1    Legal Proceedings

         Reference is made to Note 3 to the Company's consolidated financial statements of this
         Form 10-Q.

    2    Changes in Securities                                                                          None

    3    Defaults upon Senior Securities                                                                None

    4    Submission of Matters to a Vote of Security Holders                                            None

    5    Other Information                                                                              None

    6    Exhibits and Reports on Form 8-K

         (a) Exhibits

             (i) 10.30 -Amendment No. 4, dated as of March 18, 1998, to Credit Agreement
                        dated as of January 7, 1997, among Brookwood Companies Incorporated,
                        Kenyon Industries, Inc. and Brookwood Laminating, Inc., as Borrowers
                        and The Bank of New York, filed herewith                                        Page 24-27

             (ii)       27 - Financial Data Schedule                                                    Page 28

         (b) Reports on Form 8-K                                                                        None
</TABLE>





                                    Page 22
<PAGE>   23
                THE HALLWOOD GROUP INCORPORATED AND SUBSIDIARIES

                                   SIGNATURE

    Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.



                                         THE HALLWOOD GROUP INCORPORATED



Dated: August 12, 1998                   By:   /s/ Melvin J. Melle            
                                            ----------------------------------
                                             Melvin J. Melle, Vice President
                                              (Duly Authorized Officer and
                                                 Principal Financial and
                                                 Accounting Officer)





                                    Page 23
<PAGE>   24

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>

EXHIBIT
NUMBER                      DESCRIPTION
-------                     -----------
<S>                      <C>
10.30                Amendment No. 4 to Credit Agreement

27                   Financial Data Schedule
</TABLE>