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Starwood's ITT deal may be the start of another hot year

1997 is shaping up to be a record year for the hotel industry, and it looks like '98 will be hot, too.

For a little more than two weeks, Thomas Flexner and his group at Bear, Stearns & Co. in New York pulled all-nighters for Barry Sternlicht to get the deal done for Starwood Lodging Trust's initial $82 per share bid for ITT Corp. on Oct. 19. But little did his team know that the war had only just begun. Now it is widely known that after Hilton Hotel Corp. re-entered the fray with a competing bid and then Starwood upped the ante to $85 per share, on Nov. 12 a majority of ITT's shareholders approved the election of the ITT-recommended board of directors, thereby finally sealing the fate of the Starwood acquisition.

For Flexner and his advisory team, it was worth the work. "I feel like our group has consisted of vampires now. One of our senior associates looked like he had stepped out of the jungle after the Tet offensive. People were pulling 24-hour shifts, there was so much to do," says Flexner.

And while everyone makes a big deal of "relationships," in this case, it really meant a lot. That's how Bear Stearns became Sternlicht's closest adviser.

"We've been a banker to them for a few years, so he's (Sternlicht) had a positive experience in dealing with myself, with my group and with the firm. We've been in his major equity transactions, we've advised him on other M&A transactions historically. When the transaction between Westin and Starwood was being negotiated (where Sternlicht was a 50% partner in a group on the Westin side and was effectively selling to himself) we were retained to represent Barry and his selling group as a selling partner of Westin. Barry and his wife and my family are good friends. We vacation together, so there's a lot of personal history. He knows that we've got a very strong M&A skillset. He trusts us. We have the No. 1 Institutional Investor-ranked gaming analyst, and this transaction had a meaningful gaming component. We've become a pretty meaningful factor in the lodging sector so he knew we had lodging expertise."

But it really all started with a simple phone call. "We called him the morning after the Nevada court ruled that ITT would have to go to a shareholder vote and said, 'This might be an interesting opportunity for you to talk to ITT.'"

In fact, it turns out Sternlicht had already beaten Flexner to that scenario and had already conversed with ITT. "When we called him that morning, he said he had just faxed ITT, so we both opened up the paper and came to the same conclusion that morning."

The conclusion was based on an Oct. 18 Nevada court ruling that said ITT must hold a shareholder meeting to vote on its proposed spin-off into three separate public corporations. Interestingly, the California Public Employees' Retirement System (CalPERS) of Sacramento, Calif., filed an "amicus curiae" in Nevada federal court to prohibit ITT's spin-off until a vote by its shareholders was completed.

"When the Nevada court ruled the way they did, we perceived and he perceived that there might be an elevated interest on the part of ITT management to consider alternative strategies, so Barry collectively arranged to meet with them and discuss whether there was something that was worthwhile moving forward with," says Flexner.

"We agreed with ITT that there was definitely mutual interest in discussing whether something could occur. We traded information, signed confidentiality agreements, we agreed that we would try to pursue a very rapid and intense timeframe. Our role really over a two to two-and-a-half-week period between that initial meeting with ITT and the signing up of a definitive merger agreement we worked around the clock extremely closely with the Starwood people to develop a merger model that would enable our client to evaluate the various constituent parts of ITT and would allow them to be flexible in terms of gaming out different scenarios in terms of what businesses should be kept, what businesses should be financed or sold, different capital structure, strategies. So we helped them evaluate the businesses. We actually walked the gaming properties with Starwood people, with senior bankers of ours. We helped them design a negotiating strategy in terms of working with ITT. So I would say we were very closely tied in as an adviser in terms of helping assess the businesses, helping develop tactical opportunities and helping them get to the point that they could sign a merger agreement."

"We also helped them line up the bank group. We provided them a highly confident letter along with BT (Bankers Trust) so they could know the financing would be in place when they needed it," says Flexner.

No question this deal took the industry totally by surprise. Why? "Remarkably so, nothing leaked," says Flexner. Considering the number of players on both sides of the deal, that's an amazing feat. "There were a lot of parties involved, working in a highly coordinated fashion, and we were able to keep a lid on it. I don't think it was so much of a surprise that, at the end of the day, the transaction happened. I think the surprise was really amplified by the suddenness, with no prior speculation."

How do the two pieces fit together? "It's almost a utopian fit. Clearly they've (ITT) got world-class gaming brands. But I think even more importantly, is the compatibility and the fit of the lodging brand. They've got the five-star Luxury Collection, Barry's heading Westin, which is an absolutely strong, four-star brand, now they'll be adding Sheraton, which is a three- to three-and-a-half-star brand and in some markets a four-star brand, and Four Points, which is a two-and-a-half-star full-service brand."

"So what this does is it puts under one roof a brand array going from two-and-a-half to five stars, so there's very little redundancy in that regard. It enables Starwood to reflag other hotels that they have that are not necessarily appropriate to become Westins as Sheratons. There are tremendous synergies there. Some Westins might be reflagged as Sheratons and some Sheratons might be reflagged as Westins. It really allows the company to calibrate the flagging strategy on a property by property basis. The operating synergies are very strong. It gives Starwood a far more geographically diverse growth platform," says Flexner.

"Sheraton is an extremely well-managed brand, well-known throughout the world, and so is Westin, and both are highly regarded. Under ITT, Sheraton has been extremely well maintained. I think ITT's been very smart in protecting that brand, which is why it's so attractive. They've got great management bench strength, they've got a leading state-of-the-art reservations system and computer technology. There are just a lot of cross-selling opportunities."

Flexner has been with Bear Stearns for four years. Previously he was co-head of investment banking at Eastdil in New York.

"I'm here for the duration, as long as my energy level holds up. We're committed to this business. We think it's going to have longevity. We've been very careful to size the growth in our resource base here with the market opportunities. We have a group esprit that says, 'Let's work hard and work overtime when the markets are strong and take comfort in the fact that, if the market does turn, there's not a fear of overhead overhang.' That's how we manage this business."

This drive and enthusiasm seem to be perking throughout the hospitality industry. In fact, it looks like Starwood's play for ITT could be just the start of another hot year.

As good as it's ever been Ask Bill Gudenau, chairman of Chicago-based Hotel Partners, what the state of the hotel industry is and he'll answer immediately.

"I think it's as good as it's ever been," he says. "1997 will go down as an absolute record year for investment transactions. It's going to be a record year for our business. We've more than doubled our business and are projecting a 50% increase in 1998. We'll start the year with 130 listings, which will be up 50% to 60% over last year."

Business is very good indeed, he adds, noting that hotel owners are taking advantage of capital markets, particularly since there is a lot of capital available and competition for product pushing prices higher.

"Will that hold? I think we'll have a good five-year run," Gudenau adds. "The next five years should be strong, with the only softening in markets with too much product. Probably the biggest concern any investors should have right now is construction of new product. There may be over-building in some markets of certain property types."

Thomas F. Hewitt, president of the Hotel and Resorts Division of Carnival Hotels & Casinos, is equally enthusiastic about the hospitality industry's prospects. "The hotel industry has excellent fundamentals," he says. "I like to tell people we're still in a state of euphoria tempered by reality. It's a marvelous time to be in the industry. Basically, those fundamentals are going to continue where overbuilding is not a problem, and it's not on the horizon, except possibly for limited service in some areas."

Hewitt said he expects to see rate growth continue, and while they won't be in the double digit area, they will be healthy and ahead of inflation. "I don't think we'll see a significant amount of growth in occupancies because we've already seen that, but if you maintain that, coupled with decent rate growth and occupancy efficiency and flow through, we're going to have a very good bottom line," he adds.

Consolidation will increase efficiency Consolidations in the industry -- CHC's hotel management assets, its 50% interest in Gencom American Hospitality was merged with Patriot American Hospitality Inc. and Patriot American Hospitality Operating Co. -- will create efficiencies and increased brand strength.

"We're constantly finding new ways to increase productivity, whether it's reliance on technology, new products, innovations, new styles or methods of management," Hewitt adds. "We'll see some improvement, but it'll be nowhere near the jumps we've had in the past two, three or four years."

Robert Morse, president/franchise of ITT Sheraton Corp. in Atlanta, notes the hospitality industry has definitely experienced a boom over the past several years. "A lot had to do with pent-up demand; room rates hadn't experienced growth," he says. "The economy came back strong, and there was little new inventory coming into the market. We were in a position to really get this increased demand without having to deal with increased supply. It's been a long time since we haven't had to deal with an increase in supply."

Over the next several years, Morse sees activity leveling off, however. "I don't think we're going to see the rate increases that we've seen over last three or four years," he adds. "The rate growth is going to stabilize at the very high end."

The luxury market, including five-star resorts, will continue to remain strong since the barriers to entry are very high. "Either you can't get the right location or there are environmental issues involved in trying to build a resort," he adds. "Trying to build first-class hotels in major metropolitan areas is also difficult, since it's difficult to get the right location."

As for limited-stay and extended-stay products, Morse says developers need to be smart. "You don't need five 100-room projects, crawling over each other," he says. "You have to have a well-thought-out plan ready. You don't want too much supply and too little demand."

The hospitality industry has good solid fundamentals on full service, and reasonably good for resorts, says J. William Sharman Jr., chief executive officer of Lancaster Hotels & Resorts, a Houston-based small luxury hotel company. "But you go down the economic ladder and it becomes more problematical because of overbuilding," Sharman says. "A lot of markets are going to get zapped because there's so much construction, and there will be way more supply than demand, particularly in limited service."

The industry hasn't see much development of full-service hotels, he adds, so the big markets are strong and getting stronger. "In some of the markets -- like Boston, San Francisco and New York -- they can't do anything but move room rates," he explains. "For travelers, it's not a question of paying for a room, it's simply getting a room."

The consolidation that has been sweeping the industry will continue, Sharman adds, because companies need to reach critical mass for marketing and purchasing power, among other needs. But there needs to be an assimilation period. "Patriot American, Gencom, Carnival, Wyndham and others are having to digest some big acquisitions," Sharman continues. "Once they do that, they'll gear up behind the brand."

He envisions more expansion of brands -- to places such as South America -- as well as hotel companies taking a harder look at the retirement/assisted living situation and timeshare.

"Timeshare is going to be a real growth vehicle," Sharman adds. "Just look at Marriott. It is getting more aggressive. They sold out their Boston (timeshare) project before it was finished and are actively scouring Boston for another. I think timeshare is going to be a big growth area. Up till now, some of the hotel companies have only tip-toed in."

Looking ahead Yet while the fundamentals for the industry still appear exciting, and companies are exploring new venues such as timeshare, some analysts like Dr. Bjorn Hanson, industry chairman/lodging and gaming at Coopers & Lybrand LLP, are looking further ahead into the new millennium. Hanson says that many are now blinded by the fact that the industry's profit was $14.5 billion this year and is expected to be some $17 billion next year.

"All that sounds good, but if you look behind the big numbers, there are a few things going on," he continues. "We're indicating occupancies are expected to drop two full percentage points for the country. Those aren't bad numbers, but the trend is a downward direction. That has implications for what will happen with the average room rate. I'm stressing the industry isn't in a crisis period, but a period when profit growth will slow."

For instance, Hanson says new construction of hotel rooms should be considered. About 127,500 new rooms were started this year -- the third highest number in industry history. The highest amount of hotel room construction was 156,000 units in 1985. Hanson notes that most analysts thought that was too much hotel construction.

As for the terrific increase in profits, he notes that from 1988 to 1993, hotel room rates didn't keep pace with inflation. However, over the past three years, that situation has dramatically changed and rates have grown tremendously. But if occupancy drops, then hotels will compete more on the basis of price -- which is not the healthiest situation for the industry.

"Another thing to watch is that we're starting to see a change in the makeup of public companies," says Hanson. "Today, almost all the income of the lodging industry is from the operation of the business -- franchising fees, management fees, etc. But as we start to see public companies dispose of assets, we'll see an increasing level of profits derived not from the operating business, but from the gains on the sale of assets."

For instance, if a company bought a hotel at $40,000 per room and sells it the next year at $80,000 per room, the company has made a terrific return on its investment -- and is generating profits through other means. "You have to watch the ratios," Hanson continues. "If we get to a point where percent of net profits of industry come from gains on sales of assets, it's a measure that we passed through the third phase of the business cycle, which is maturity, and into the fourth, which is decline. Keep in mind, I'm not projecting a decline two years out but saying we simply have to watch those ratios."

More mergers and acquisitions Analysts will also be watching as the industry becomes more concentrated. Consolidation will continue to occur in the years ahead, reports Dana Michael Ciraldo, senior vice president at Hodges Ward Elliott in Atlanta. "It just doesn't make sense to have so many hotel owners," Ciraldo says. "Efficiencies not being achieved in the market place. The hotel industry will consolidate just like the oil and gas, rubber and automobile industries have been consolidating -- down to a handful of players dominating the industry."

That means more mergers and acquisitions. "In today's hotel industry, you're either a consolidator or a consolidatee. You either swallow up companies like a Starwood, or you're the one who is swallowed up by a Starwood," he says.

At the same time, Ciraldo says the industry is headed toward more globalization. "We're going to see more U.S. investors gravitate outside the United States," he continues. "Typically, we have seen global investors come to America, not the other way around. Increasingly it's going to be in the other direction. Very few American-based companies have operated outside the United States."

And those investors may have some global opportunities, just as they have in the American market. Already, there are some areas of concern in the world outlook. Wolf H. Hengst, president, Asia Pacific Four Seasons * Regent Hotels and Resorts, notes the hospitality industry is having a difficult time in some parts of Asia due to the magnitude of the financial markets' decline.

"Business travel is holding up fairly well, but all other associated business -- groups, corporate meetings, etc. -- is down," says Hengst. "I believe 1998 is going to be rough throughout Asia. Hong Kong has been hardest hit. Commercial travel is fine, but leisure travel has dropped on average in hotels by 20 percentage points with no relief in sight. The Japanese market, Hong Kong's most important, has come to a halt."

Hengst, a hotelier for more than three decades at postings throughout the world, says that after next year, he believes things will bounce back. "The long term continues to show potential throughout Asia from India (with great potential) to China, Vietnam, and even Cambodia and Burma once the political situation straightens out."

But now, Asia hoteliers are worried about Malaysia, specifically Kuala Lumpur. "The amount of hotels coming on stream is irresponsible," he adds, "and there is virtually no growth in travel."

Overbuilding worries Even so, Gudenau of Hotel Partners notes that the luxury hotel market is pretty safe right now, adding that so are the full-service and mid-market sectors. "Occupancies are strong, and maybe some sub-markets are softening," he says. "The budget and limited-service segments may be overbuilt in some markets. The only cloud on the horizon is the danger of overbuilding, but I think the capital markets will keep that in check. No one is going to make the mistakes that were made in last part of the 1980s. When the markets are saturated, the flow of capital will stop. There just won't be the lending."

Yet some see the silver lining even in the much-discussed limited-service segment of the industry. The industry is cyclical, and being involved in the limited-service sector is like buying steel companies or fast food restaurants on the stock market -- the long-term fundamentals are fairly strong, notes HWE's Ciraldo.

"Basically, we're in a boom economic time right now, so staying in full service hotels is popular now," he says. "But the minute the economy hiccups, people will be trading on down and limited-service will be the darling of the industry. The lodging industry is a cyclical business. Full-service hotels do well in boom times and hurt in recessions. Limited-serviceis the opposite: They do better in recessions than in boom times."

Ciraldo says the cycle won't be turning around in the next few years, but perhaps five years down the line. "But people don't have that sort of time horizon," he says. "Unless something dramatic happens with interest rates or the stock market, I see a long comfortable ride here."

William J. Hoffman, president of Trigild Corp., a San Diego-based hotel management company, agrees. "Those luxury or budget extremists who sound the death-knell for the mid-priced limited-service property will continue to be proven wrong, as they always have," says Hoffman. "In down markets, these mainstream properties can survive nicely at rates that will bankrupt the glamour hotels, and in up markets, they can ride the rate escalator like no budget motel ever can. When all the smoke clears, they generate real, honest-to-goodness operating profits which are the envy of all other segments.

Hoffman also questions the enthusiasm between "the Street" and "REITs", noting that nearly every story he's read recently mentioned the effect hotel REITs or Wall Street were having on the industry. "This is the long-term question which must be reconciled, probably near the millennium: Will these companies prove as adept at generating hotel operating profits as they are at pumping share prices?"

He notes that there are significant challenges facing hoteliers; finding, attracting and keeping good people will always be the toughest problem. In spite of the growth of technology, he explains, the smiling face at the front desk will continue to have greater impact on the guest experience than any other.

"As we try to gain more revenue per guest, rather than simply revenue per room, 'high touch' will always be far more important than 'high tech'," says Hoffman. "Considering how often hoteliers refer to this industry as a 'people business' it's astounding how little attention we pay to the impending problem -- if not disaster -- we face in finding, training and retaining competent employees."

With industry fundamentals about as good as they get, many in the lodging industry say the hospitality sector of the economy is set for smooth sailing -- although there might be a few bumpy waves along the way.

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