Lifestyles of the Rich and Almost Famous: The Boutique Hotel Phenomenon in the United States

High Tech Entrepreneurship and Strategy Group Project

Professor Ron Adner

Alec Albazzaz Beth Birnbaum Daniel Brachfeld Max Danilov Oriane Kets de Vries James Moed

Table of Contents Executive summary.................................................................................................................... 4 Background on the hotel industry.............................................................................................. 6 Hotel industry economic factors ............................................................................................ 6 Hotel industry trends .............................................................................................................. 7 Segmentation of the market.................................................................................................... 8 Growth of branded hotel chains ........................................................................................... 10 Major players ........................................................................................................................ 10 Chain hotels and independents............................................................................................. 10 Boutique Hotels: a definition ............................................................................................... 11 The evolution of the boutique hotel..................................................................................... 12 Strategy Analysis of Boutique Hotels ...................................................................................... 13 Ian Schrager Hotels (ISH) ........................................................................................................ 16 Hotel as Theater ................................................................................................................... 16 Location............................................................................................................................ 16 Design............................................................................................................................... 16 Experience........................................................................................................................ 17 Restaurants ....................................................................................................................... 18 Marketing ......................................................................................................................... 18 Targeting / Pricing............................................................................................................ 18 Growth Strategy ............................................................................................................... 19 Reaction to Competition....................................................................................................... 19 Starwood/W Hotels .................................................................................................................. 21 Starwoods Timing and Approach of Entry......................................................................... 21 Timing .............................................................................................................................. 21 Value Proposition............................................................................................................. 21 Starwood/Ws Financial Structure, Support and Ownership ............................................... 22 Economics of construction and operations ....................................................................... 22 Does Size Matter? ............................................................................................................ 23 W Hotels Financial Review .............................................................................................. 23 The W Experience................................................................................................................ 24 Amenities ......................................................................................................................... 24 Restaurants and bars......................................................................................................... 24 Meeting rooms .................................................................................................................. 25 Catalogue and the W Store ............................................................................................... 25 Starwoods Competitive Advantages ................................................................................... 25 Corporate Structure .......................................................................................................... 25 Cost Savings Through Economies of Scale and Scope.................................................... 26 Quality of Service............................................................................................................. 27 Locations .......................................................................................................................... 27 Willingness To Pay .......................................................................................................... 27 E-strategy ......................................................................................................................... 28 Marketing and Public Relations ....................................................................................... 28 Growth Strategy and opportunities .................................................................................. 28 Long term strategy ........................................................................................................... 29 Boutique Growing Pains .......................................................................................................... 29 Conclusion: Is Ian Schragers approach to hotels sustainable? Will W outperform ISH? ..... 30 Pictures..................................................................................................................................... 32 W Hotels............................................................................................................................... 32 Ian Schrager Hotels .............................................................................................................. 35

Exhibits..................................................................................................................................... 37 References: ............................................................................................................................... 48

Executive summary
The US hotel industry has traditionally been extremely fragmented. Many small players initially entered the market by acquiring and renovating a local property, and maintaining it as a small business or building it into a small regional chain over time. As US consumers became more mobile and a growing cohort of frequent business travelers emerged, many travelers developed a higher willingness to pay for a branded hotels comfort, cleanliness, quiet, reputable service, and provision of a good nights sleep. Hotel brands are traditionally segmented by quality, generally falling into one of the following category types: economy, midscale, upscale, upper -upscale, and luxury. Specific hotels can segment further based on location, desired customer type (business vs. leisure), and hotel size. Luxury and upper upscale hotels traditionally feature a wide range of fine services and amenities (multiple restaurants and bars, spa services, concierge services, toiletries), large rooms, and premier urban and resort locations. Upscale properties tend to cater more specifically to business travelers and groups, while retaining an emphasis on quality and comfort. Midscale and economy hotels are generally geared for short-term transient business and offer stripped-down features at a lower price point. The major US players in hotel ownership and management, namely Marriott, Hilton, 6 Continents, and Starwood, all maintain a wide portfolio of hotel brands (please note that we have considered the purely franchised hotel business as outside the scope of this paper). In the 1980s and 1990s, extensive consolidation took place in the US hotel industry, producing several large chains that now control a large portion of US lodging capacity, especially in the midscale and higher segments. These large, relatively stable companies can obtain financing to develop many properties simultaneously and can develop more cost-effectively than smaller players. Chains also benefit from economies of scale in operations, a centralized reservation system that allows them to yield-manage more effectively than independent hotels, and a well-developed sales and marketing organization that can attract group business. The major players have also diversified their activity from pure hotel operations. In addition to owning, manag ing, and franchising properties under the flags of their brands, their businesses now include real estate, time-shares/vacation ownership, car leases, and food distribution. In the past 20 years, a small but growing contingent of travelers, grown tired of staying in large, personality-free hotels geared towards a mass audience, has begun to migrate towards a new, more intimate breed of hotel. These travelers purposefully seek out properties that are noticeably different in look and feel from branded hotels, choosing an element of surprise over the more straightforward values of consistency, comfort and convenience. A formal definition of the boutique or lifestyle hotel concept remains elusive, though pundits agree on the following criteria: a thematic , architecturally

notable design offering warmth and intimacy, a relatively small number of rooms, and a target of upmarket 20-55 year olds. The innovation of the boutique hotel is most often credited to Ian Schrager. Famous for co-founding the legendary nightclub Studio 54, Schrager saw an opportunity to sell an alternative to the massmarket hotel experience. The 1984 launch of Morgans in New York was Schragers attempt to market a hip, unusual hotel experience by telling image-conscious customers you are where you sleep. Schrager had purchased a rundown hotel previously frequented by derelicts, and with the help of a well-known French interior designer, created a dramatic nightclub-like environment populated by a staff of part-time models and actors. Over the next two decades, the Schrager formuladistressed property, powerful thematic design, and limited amenities was recreated in ten more locations from London to Miami. Each propertys centerpiece is a hip restaurant or bar leased to a famous chef or restaurateur. These hotspots attract celebrities and a sophisticated local clientelegenerating buzz and profits. Other entrepreneurs quickly followed Schragers lead, and independent hotels across the US rushed to re-brand themselves as boutiques. Major players in the industry also took notice and quickly tried to exploit this growing market: Starwood Hotels and Resorts opened the first W Hotel in Midtown New York in December 1998. Closely following the Schrager model, each property offers signat ure restaurant and bar areas that attract not only the hotel guests, but in-the-know local residents as well, according to the W Hotels website. However, W rejects the boutique label, preferring to call itself a lifestyle brand, and now (in the wake of the effects of September 11), emphasizes its customer service aspects. Although the W brand had to overcome initial industry doubts that no chain hotel could successfully emulate the boutique experience, Starwood claims that W is the most successful hotel launch in history and has opened 17 locations since 1998. Being a Starwood brand provides each W hotel economies of scale in purchasing and maintenance, synergies through Starwoods guest reward program, the Starlink central reservations system, and access to Starwoods group and meetings sales force. Our analysis aims to uncover the extent to which the boutique hotel concept is truly an innovation over the traditional luxury hotel. By introducing a powerful new aesthetic and eliminating amenities previously considered de rigueur, boutiques, led by Schrager, appear to have distinctly altered the industrys value proposition. We hope to determine if these advantages are value creating, and more importantly, sustainable in the face of increased competiti n and an uncertain economy. Boutique o hotels are highly leveraged, meaning that they attract the highest-revenue customers during times of peak business travel. By keeping costs low and maintaining high demand with an aura of style and exclusivity, Ian Schrager Hotels have been able to achieve operating margins as high as 45%. However, their leverage makes them especially vulnerable in times of decline; because boutique hotels

offer limited or nonexistent meeting space, they cannot fall back on group sales to fill rooms when individual business travel declines, and thus must let them go empty or sell them at distressed rates through potentially brand-diluting wholesalers. Boutique hotels experienced tremendous growth during the economic boom of the late 1990s, but can they survive now that the bubble has popped?

Background on the hotel industry Hotel industry economic factors

The development of the hotel industry has been linked with the international and domestic tourism and travel sector in general. The economic growth of the 90s and the accelerated globalization of the world economy significantly increased business and leisure travel. The development of travel infrastructure and the decreasing cost of air and other forms of transportation have also driven growth. Today, tourism is the third largest retail industry in the United States. Total US hotel industry revenue rose from $62.8 billion in 1990 to $103.5 billion in 2001, while the average daily room rate (ADR) grew from $58.08 in 1990 to $88.27 in 2001 (See Exhibit 1). i Much of this rapid growth has been spurred by the middle and low end, while increased consolidation within the industry has put pressure on the independent hotels to innovate at the risk being bought out. Historically, demand for lodging has been highly correlated with GDP growth. According to

PriceWaterhouseCoopers, demand elasticity to GDP is normally 1.0. Exogenous shocks such as the Gulf war of 1990-1991, the Asian financial debacle in 1998, and the terrorist attacks of September 11, 2001, have distorted this relationship. Additional factors that affect lodging demand include consumer confidence, interest rates, cost of transportation (fuel prices, indirect taxation), and foreign exchange rates. (See Exhibit 2) Supply for lodging tends to lag well behind demand, since it takes several years to bring new capacity onto the market. In addition, market segments influence supply, as upscale and better hotels take longer to complete than lower -range properties. Furthermore, deve lopers have limited flexibility to defer or accelerate projects. In 3Q 2002, total lodging supply stood at 4.2 million rooms, while 2002 total turnover in the hotel industry worldwide was estimated at around $280 billion. (See Exhibit 3) At a microeconomic level, the main factors of industry profitability are: Occupancy rate (OCC) and ADR are both driven by the demand-supply relationship. There are stark differences in the performance of hotels according to location and type of customers. Hotels relying on international travelers have been most affected by current slump in demand. Market segmentation is also a key factor; economy hotels are more resilient during demand downturns than upscale properties. A hotels ADR and OCC determine its main revenue indicator: its Revenue per Available Room, or RevPAR.

Operational leverage. The ownership structure of its hotels has a significant effect on a hotel chains profitability. Hotel ownership is a more leveraged structure than franchising; it is difficult for properties to adjust operating costs when occupancy rates drop during market downturns, but franchise and other fees are a more consistent source of revenues. Similarly, in good market conditions, owned hotels perform better than franchises for the parent company.
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Hotel industry trends

Several trends characterize the state of the international hotel industry over the past decade (See Exhibit 4 for a more detailed history). Consolidation: A number of large deals serve as examples of this important trend, such as the Starwood acquisitions of Westin and Sheraton, the Doubletree and Promus merger deal, the Marriott acquisition of the Renaissance Hotel Group, and the merger of Hilton and Hilton International. This consolidation has created hotel companies with greater brand portfolios and greater global reach. Increased globalization: Industry consolidation has encouraged overseas investment, increasing the reach of many hotel companies. One example is the Marriott International, who recently purchased the Hong-Kong based Renaissance Hotels. In addition to global growth through acquisition, many USbased hotel companies are expanding their brands worldwide. In 1996, there was a rapid international spread of US -based economy and mid-priced franchised hotel chains. Increasing importance of finance: Financiers are increasingly driving the hotel industry. Hoteliers have traditionally focused on internal operations, while financiers concentrate on earnings and company growth. Although some say that this shift forecasts a more difficult negotiating environment for travel buyers, others herald the transition as a positive step towards a stronger and more successful industry. Wall Street has only recently developed an interest in the lodging industry, which it long considered too risky and unstable. The role of information technology: In 1996, it was estimated that hotel companies in the US and Europe spent an average of 2.5% of their revenue on information technology. Slightly less than $2 billion was spent n the US and $2.5 billion in Europe. In the 1980s and early 1990s, the hotel i industry spent several billion dollars on technology, but most of that spending was kept in-house. Many hotel companies now feel their proprietary technology is a key point of differentiation. Industry consolidation has driven an increased appetite for spending with outside systems integrators, outsourcers, and software developers. Many technology innovations have been driven by the Smart cards, check-in kiosks, and the industry's need to enhance the customer experience.

proliferation of loyalty programs are all examples of hotel companies trying to get closer to their

customers. Because many hotel companies internally developed and purchased disparate systems, they now face a need for systems integration as the industry consolidates. Distribution costs also continue to be high. The changing role of the Internet, managed travel, and the evolution of the global distribution systems (GDS) used by travel agents to access air, hotel, and rental car inventory, will likely cause changes in the way hotel rooms will be distributed in the next several years. iii

Segmentation of the market

There are many ways in which to segment the hotel industry, the most relevant ones are highlighted below: Segmentation by scale (level of luxury) splits the hotel industry into several segments. Industry practice divides hotels by scale into the following broad segments: Economy, Midscale (with and without food and beverage), Upscale, and Upper Upper Scale (including luxury hotels).iv (See Exhibit 5) Thus Marriott markets its flagship Marriott brand to the full-service upscale segment, where it competes with Starwoods Westin and Sheraton, as well as Hiltons Hilton and Doubletree brands, among others. Ups cale hotels primarily target business travelers and are generally located in prime locations in urban destinations. [To a lesser extent, upscale hotels can also be found in resort destinations, where they cater primarily to leisure travelers and groups. Generally speaking, business destination hotels yield-manage with higher price points during the week, and sometimes struggle to reach desired occupancy rates on weekends, especially during off-peak periods in seasonal destinations. The reverse is true for leisure destinations.] Upscale hotels will frequently advertise promotions and package deals to sell off their unsold inventory, and frequently sell distressed inventory through Priceline.com and other similar channels. Luxury brands such as Ritz-Carlton (owned by Marriott) and Four Seasons target the small but extremely lucrative Upper Upscale segment. These hotels will offer the greatest range of luxury services and charge a premium price; large and comfortable rooms with elegant appointments and fixtures, extensive restaurant and bar facilities, high-end shops, spa facilities, and premier locations are all de rigueur. Upper upscale hotels will generally let rooms go unsold rather than be shown to offer any sort of discount, although they will market packages bundling meals or services with hotel rooms. Midscale hotels target traveling businesspeople and families unwilling to pay for the full range of services in an upscale hotel. These properties offer fewer and less sophisticated restaurant and bar facilities than upscale hotels (or eliminate them altogether and instead offer a free continental breakfast of pastries and cereal). These hotels are generally located in urban areas, but unlike the upscale hotels located in prime downtown locations, midscale hotels will generally be found in suburban and highway locations. Holiday Inn Express, Ramada, Fairfield Inn by Marriott, Four

Points by Sheraton, and Hampton Inn (a division of Hilton) are all examples of branded midscale hotels. Economy hotels c onstitute a large segment of the market. Hotels carrying the flags for brands such as Days Inn, Travelodge, and Super 8 (all franchised by Cendant), Motel 6 (Accor) and Prime Hospitalitys AmeriSuites and Wellesley Inn and Suites are frequent sights along major US Interstates. These hotels (often referred to as motels in the United States) offer a limited range of amenities and services. Furnishings are basic, swimming pools are less common than in other segments, and few toiletries are offered. Many do not have an attached restaurant, for example, although it is common to see a restaurant located within walking distance of an economy hotel. Many economy hotels are franchises owned and managed by small businesspeople; franchisees are generally not considered to be able to offer the same consistency of quality of service as hotels owned or managed by the parent company. Segmentation by location: Location can be used to attract a targeted customer segment. Airport hotels are for example focused on the transit travelers in the same way as resort hotels are targeting the leisure segment. (See Exhibit 6) Segmentation by size: Hotels of more than 300 rooms account for only 21% of existing capacity. Larger hotels are an urban and resort phenomenon, whereas small hotels dominate in smaller cities and along highways. (See Exhibit 6) Segmentation by type of customer: The key split is between leisure and business travel. According to the WTO, business travel is expected to grow faster than leisure (95% accumulated growth rate for the 2002- 2012 period vs. 90%), but business travel traffic tends to be more volatile than leisure, which makes it more highly leveraged to the business economy. Other criteria for segmenting by customer type could include booking source (such as Internet site, managed travel, telephone or travel agent), demographics and lifestyle, customer responsiveness to brand or price, etc. Boutique hotels target their customers by a combination of lifestyle and demographics, an innovative targeting mix in the hotel industry. Segmentation by style : Designer hotels present a different customer proposition than mass-market hotels. Large hotels (especially those part of a chain) have found it difficult to avoid a

depersonalization of the service and a resulting trend towards commoditization. Over time, the largest players (including Hilton, Marriott and Sheraton) began to segment the market further by offering a range of hotel types and services. Through branding, companies can pinpoint locations, price points, and level of service to attract the desired mix of business and leisure travelers.

To broadcast a consistent image of the level of quality and service customers could expect, the largest hotel companies now market brands specifically to each segment of traveler.

Growth of branded hotel chains

Traditionally, the US hotel industry was extremely fragmented. Many small players entered the market by acquiring and renovating a local property, and maintaining it as a small business or building up a small regional chain over time. Consolidation began in 1943, when Hilton became the first coast to coast hotel chain in the United States. v In the late 1950s, JW Marriott, then a successful operator of Hot Shoppe cafeterias in the Washington, DC area, expanded into the hotel industry with a Motor Hotel in Arlington, VA and subsequently began a rapid geographic expansion. vi An increasingly mobile population appreciated the consistency and quality of service and co0mfort they found at branded hotel , and as they grew, these larger companies also began to benefit from significant s economies of scale and scope. The consolidation that took place in the hotel industry in the past twenty years produced several large chains that control a large proportion of US lodging capacity, especially in the middle and upper segments. As of 2002, the four largest hotel companies in the US controlled 35% of the total room supply. All the big players have also diversified their activity away from pure hotel operations, but Cendant may have taken this diversification strategy to an extreme. In addition to hotels, Cendants many business lines include real estate, rental cars, travel technology, and financial services.

Major players
In the United States, a few major players have traditionally dominated the hotel industry. Marriott is the worlds largest hotel chain, with over 2,200 units worldwide; its brands include Marriott, Renaissance, Courtyard by Marriott, Residence Inn by Marriott, Fairfield Inn by Marriott, TownePlace Suites by Marriott, SpringHill Suites by Marriott, Ritz Carlton Hotels and Resorts, and Ramada International. Hilton owns, manages and franchises 499 hotels worldwide under the brands Conrad, Doubletree, Embassy Suites, Hampton Inn, Hilton, Hilton Garden, and Homewood Suites by Hilton. Starwood owns, manages, and franchises nearly 750 hotels under the brands St. Regis, Luxury Collection, W, Westin, Sheraton, Four Points by Sheraton, and Starwood Vacation Ownership. Other major players include 6 Continents, which controls the Holiday Inn, Crowne Plaza, and Inter Continental brands, and Cendant, a major franchiser of economy hotels. (See Exhibit 7)

Chain hotels and independents

Chain hotels dominate the US hotel market for a number of reasons. Chains are able to lower costs significantly by benefiting from economies of scale. As large, relatively stable companies, they can

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make real estate investments at a lower cost and develop properties more cost-effectively. They also benefit from economies of scale in purchasing and maintenance for existing properties, and can invest in a centralized reservation system that allows them to yield-manage more effectively than independent hotels. At the same time, many consumers have a higher willingness to pa y for a known quantitya branded hotels comfort, cleanliness, quiet, reputable service, and provision of a good nights sleep, often backed up by a guaranteethan for an unknown quantity.

Boutique Hotels: a definition

In the past 20 years, a growing contingent of travelers grown tired of staying in large, personality-free hotels geared towards a mass audience, has begun to migrate towards a new, more intimate breed of hotel. These travelers purposefully seek out properties that are noticeably different in look and feel from branded hotels, choosing an element of surprise over the more straightforward values of consistency, comfort and convenience. vii These boutique hotels, often located in renovated urban

structures such as run-down single-room-occupancy hotels, small office buildings, or older hotels, attempt to replace the cookie-cutter uniformity of a branded hotels dcor, food, and service with more individualistic offerings. A formal definition of the boutique or lifestyle hotel concept remains elusive. However, pundits agree on the following criteria: a thematic, architecturally notable design offering warmth and intimacy, a smaller size than the typical business hotel (many in the industry believe hotels larger than 150 rooms cannot be called true boutiques) and a target market of up market 20-55 year olds.viii Most boutique hotels can be found in trendy neighborhoods of sophisticated urban destinations, and many offer customers high-tech amenities such as high-speed Internet access, cordless phones and CD players with a library of music (available for purchase, of course). However, a subset of boutique hotels located in resort destinations try to achieve the opposite effect: often located in secluded areas, these hotels focus on a higher l vel of service than their urban counterparts and offer low -tech amenities e such as spa facilities, privacy, and even the absence of communications facilities as proof guests staying at the hotel will truly be able to get away from it all. ix Eliminating some features and services, such as spacious rooms and expansive lobbies, and replacing luxurious fittings with cheaper, but architecturally more interesting, replacements (such as Vermont slate for $1 a foot instead of imported marble at $8), allows these hotels to charge customers a similar or slightly lower price point than upscale branded hotels, while lowering costs significantly from the typical upscale independent hotel. x Architectural design compensates for smaller rooms whenever possible (often permitting the hotel to pack more guests into a smaller space and/or renovate an existing SRO or other nontraditional hotel building less extensively and thus save money). For example, in the W New York-Times Square, where rooms average only 280 square feet, the

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architecture firm Yabu Pushelberg designed a translucent floor-to-ceiling panel of white polycarbonate plastic to replace the solid wall between the bedroom and bathroom.xi Another significant cost savings for independent boutique hotels is the fact that they do not have to pay a franchise fee to attract customers. xii Centering the hotel around a brand-name chefs restaurant (and often a trendy bar) in space leased from the restaurant also allows these hotels a significant revenue stream in comparison to the typical branded hotel, for whom these services are generally not revenue drivers. As a result, some analysts calculate that boutique hotels earn margins 30% higher than those of standard luxury hotels. xiii By building a thematic image powerfully conveyed throughout the property and relying heavily on celebrity guests and public relations rather than mass advertising and a sales force to convey a hip image, boutique hotels can successfully enter markets with high barriers by converting buildings not normally suitable for hotel use. xiv Customers who want the experience of staying in a boutique hotel are willing to trade off less-traditional locations and room designs that do not meet standard definitions of comfortsuch as the rooms in Ian Schragers Royalton Hotel in New York, which run parallel to the hotels hallways rather than perpendicular.xv Generally, rooms are smaller than normal and often relatively dark. The hotel compensates for these flaws by providing a comfortable lobby space that provides a Home Away From Home outside the bedroom itself and is a social huband new kind of gathering space for guests and locals alike.xvi Ideally, the guest spends so much time in the lobby, restaurant, and later the bar, that he or she barely notices the relatively small size of the room. Despite all the distractions, the typical lifestyle hotel guest is traveling on business rather than pleasure: according to PwC, 68% of guests are corporate travelers. xvii

The evolution of the boutique hotel

A number of market dynamics accelerated the acceptance and the demand for boutique hotels. These include: Eroding brand loyalty among franchises; customer access to the GDS via travel websites (and their subsequently reduced dependence on travel agents); the emerging t end of experience or r adventure travel; an increase in disposable income in conjunction with the largest sustained period of economic growth in U.S. history; and the desire for more personalized service (particularly on the part of discriminating business travelers).

The innovation of the boutique hotel is generally credited to Ian Schrager. Famous for founding the legendary nightclub Studio 54, Schrager saw an opportunity to sell an alternative to the mass-market hotel experience. The 1984 launch of Morgans in New York was Schragers attempt to market a hip, alternative hotel experience by telling image-conscious customers you are where you sleep. While Andre Putnam, the French stylist, designed that hotel, Schrager has maintained a design partnership with noted designer Philippe Starck since 1987, and has only recently begun working with other noted

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architects and designers, including the Canadian Bruce Mau. xviii Schrager has created a new breed of urban hotels that offer guests high style at prices lower than those of traditional luxury hotels. By building the hotel around an A-level restaurant and bar designed to attract a sophisticated local clientele in addition to the hotels guests, Schrager successfully gives each of his hotels a unique identity that also reflects the spirit of the hotels local urban environment. As many of the traditional franchised product developers recognized this powerful and profitable market segment, they too began to consider the compelling factors: the restrictive nature of most franchise agreements, the considerable franchiser costs (royalty, reservation, marketing, application fee, etc.), which range up to 12 percent of gross income, the inconsistency between franchised products, the premium revenue per available room of boutique hotels vs. luxury hotels and, finally, the barriers to entry in the traditional boutique hotel marketplace. As a result, other entrepreneurs quickly followed Schragers lead, and independent hotels across the US tried to re-brand themselves as boutiques. Major players in the industry also took notice and quickly tried to exploit this growing market: Starwood Hotels and Resorts opened the first W Hotel in Midtown New York in December 1988. Closely following the Schrager model, each p roperty offers signature restaurant and bar areas that attract not only the hotel guests, but in-the-know local residents as well, according to the W Hotels website. xix In fact, Starwood even hired Rande Gerber, designer and operator of Schragers bars (and a celebrity himself, married to supermodel Cindy Crawford, able to tap into a network of VIPs as his clientele) away from Schrager to design and manage the W hotel bars, prompting a series of escalating lawsuits that are still unresolved.

Strategy Analysis of Boutique Hotels

The phenomenon of boutique hotels can be examined using various strategy frameworks, which can explain the fast and furious rise of these hotels in the United States.

To begin, we have conducted a hotel industry analysis (See Exhibits 8 & 9). Although the exhibits concentrate on Porters five forces on each of the Ian Schrager and W brands, they are mostly similar and can be used to look at boutique hotels versus previously existing hotel types. The main message to glean from the industry analysis is to notice how buyers and suppliers do not have bargaining power. This means that the hotel industry itself can capture most of the economic benefits of the hospitality category. Yet, within the hotel industry, it is worth noting that the internal rivalry is intense. In addition, new entry is relatively easy and the many different types of hotels guarantee that there is a large substitution effect.

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It is in this environment that boutique hotels appeared, yet another in a long list of ways that hotels have tried to differentiate themselves. The innovation of boutique hotels was not a radical change from current offerings. It was clear that the concept of boutique hotels enhanced the competence of hotel operators. Many of the current practices in the industry were kept and sometimes enhanced or lessened, but the new hotels did not represent a disruptive technology to the core concept of hotels. By combining their existing market knowledge with new ideas of what a new and different segment of customers desired, Ian Schrager and later Starwood were able to create (in Schragers case) or enhance (in Starwoods case) current offerings (see Exhibit 10: What Type of Innovation is the Boutique Hotel?). Although the concept of boutique hotels did not destroy the existing market knowledge, it did disrupt what hoteliers believed was the correct combination of product offerings to target the lucrative segment of young and upscale consumers (it is important to note that boutique hotels themsel es are v not a disruptive technology, rather a more targeted offering to a particular segment that was either ignored or underserved). The ultimate list of attributes combined in a boutique hotel is narrowly aimed at this segment, and therefore the innovation of boutique hotels can be described as niche creation (see Exhibit 11: How Disruptive Are Boutique Hotels?). One of Ian Schragers highest-impact innovations within the boutique hotel category was the creation of ber-hip restaurants and bars, which became city destinations (rather than the traditional model of pushing hotel guests into its restaurants and bars). Hoteliers shrewdly realized that their expertise lay in the hospitality industry, and not the entertainment industry (where these restaura and bars reside). nts By using alliances with well-known chefs and bar and restaurant owners rather than trying to create these on their own, boutique hotels were able to create products that their target segment actually desired and valued very highly (see Exhibit 12: Building of Alliances Between Hotels and Bars/Restaurants). Ws and Ian Schrager hotels profit sharing and revenue deals with their alliance partners will be discussed in the next sections. Apart from restaurants and bars, Ian Schrager created other valuable new factors in his hotels, while reducing or eliminating other factors that did not add value to the target segment. The framework of value innovation as it relates to boutique hotels is shown in detail in Exhibit 13 (Actions for Value Innovation). One of boutique hotels greatest advantages is the ability to offer a customized offering in a small amount of space. This was done by reducing the size of rooms and area used by non-value added items such as in-hotel shops and lobby space. The value curve for boutique hotels as compared to Luxury hotels (Four Seasons) and Upscale hotels (Sheraton) is highlighted in Exhibit 14 (Value Curve for boutique hotels).

Where did boutique hotels customers come from? These consumers were previous ly staying in the various offerings that targeted upscale travelers. Luxury hotels offer exquisite service and a top-end

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product, but they were increasingly viewed by some as stuffy, and were mostly frequented by an upscale, older clientele. Although upscale hotel brands such as Westin and Marriott offer a lower price and an adequate service and product, these hotels have increasingly been viewed as cookiecutter, offering a uniform and unexciting product. These hotels target the average businessman. In contrast, the boutique hotel provides a more targeted luxury, drawing in a younger, but still upscale, crowd (see Exhibit 15: Preference Structure).

There is a paradox present in the model of the successful boutique hotel. Naturally, given the high fixed costs and the low variable costs in the hotel industry, selling as much as possible is preferred. But one of boutique hotels value-added offerings is the feeling of exclusivity and being part of a vibrant scene. This cannot be accomplished by allowing too many people to be part of the boutique product. In terms of the innovation diffusion curve, this means that there is a forced and desired break between early adopters and the majority of adopters (see Exhibit 16: Innovation Diffusion for Boutique Hotels). One interesting way to understand boutique hotels is to see it as Ian Schragers attempt to turn a hotel into a fashion item. Therefore, the highest willingness to pay will lie in a new and attractive product. There is a way to reconcile the issue of hotel size with hotel feel: expand into new boutique hotels. The phenomenal growth of boutique hotels is currently possible because of how few of these hotels currently exist. Instead of expanding the hotel itself, the way to expand in this business and still keep the main value proposition of a boutique hotel is by increasing the number of hotels in currently underserved areas. As cities become saturated with boutique hotels (as New York might soon be), there will be a decreasing return on guests (and therefore revenues and profits), not only because of overcapacity, but also because of the limit of upscale and young consumers in the market.

Using various strategy frameworks, we have shown that the offerings of boutique hotels have both increased the target segments willingness to pay while at the same time reducing the hotels costs. This gives them a competitive advantage over luxury and upscale hotel products (see Exhibit 17: Competitive Advantage (WTP vs. Cost)). The advantage may not be sustainable though. Issues of further segmentation (more targeted hotels) and the loss of the new feel as time progresses may force boutique hotels to rethink their offerings and either further value innovate to raise willingness to pay or reduce their costs through scale.

The next sections will highlight each of Ian Schrager and Starwood timings and approaches to boutique hotels.

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Ian Schrager Hotels (ISH) Hotel as Theater

When asked to define the term boutique hotel, Ian Schrager provides a simple reply: Its a hotel with a point of view. Schrager approached hotel development with the belief that customers will pay as high a premium for attitude, glamour, and exclusivity as they will for more traditional amenities of a luxury hotel. In 1984, fresh from a 13-month jail term for tax evasion, Schrager and Studio 54 cofounder Steve Rubell turned a rundown former single-room occupancy hotel (SRO) on Madison Avenue in New York into Morgans. Draped entirely in blacks and grays, Morgans boasted provocative Robert Mappelthorpe photos on the walls, impenetrably dark hallways, small guest rooms, part-time models for staffand a devoted clientele. xx Today, Ian Schrager Hotels (ISH) has expanded the concept of hotel as theater to 10 locations in New York, London, Miami, Los Angeles and San Francisco. By starting with low cost properties such as SROs, adding powerhouse restaurants and bars, offering limited extra services, and keeping demand high by staying at the edge of cool, Ian Schrager claims to have achieved profit margins of 35% to 45%.xxi And the point of view? Schrager directs the scene and the customers willingly play their parts. Location Schrager hotels typically begin as urban properties that have some architectural distinction, but ha ve fallen into disrepair and can be acquired cheaply. The Mondrian, which opened in West Hollywood in 1997, (bought out of bankruptcy for $17 million), was previously a fifties apartment block built to evoke the work of the artist of the same name. xxii Schragers 1995 renovation of the Delano in Miamis South Beach marked the revival of a neighborhood known for its Art Deco design. ISHs acquisition and turnaround strategy is likely what attracted the attention of NorthStar Capital, which in March 1998 paid $255 million for a controlling stake in ISH (reportedly around 70%).xxiii NorthStars portfolio focuses on undervalued assets [that] possess significant revenue-generating potential [and] are either overlooked or out of favor in the eyes of mainstream investors.xxiv With the backing of NorthStar, ISH has been able to take on more ambitious investments including a May 1998 purchase for $177 million of the Barbizon and the Empire, New York properties with over 300 rooms each. xxv Design Ultimately, the Schrager developments that have succeeded prove that the value of a theatrical production is its ability to cheaply transform an empty space into an emotionally compelling environment. Beginning with French interior designer Andre Putnam at Morgans, Schrager recruit ed visionary interior designers who imbued each property with a powerful theme and an element of fantasy. The Royaltons ocean liner dcor features portholes in the bathrooms, while the Paramounts European touches extend to Vermeer reproductions over each headboard. xxvi

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Schragers main collaborator and ISH partner over the past decade has been French designer Philippe Starck, whose designs combine minimalism and extravagance. For me, a hotel is a stage where I try to inspire people to open up the door in their brains...to wake them up to realize they can reinvent their own lives.xxvii However, ego-driven design often takes precedence over practicality (one Starckdesigned shower door is infamous for its dangerously tricky handles). Like a stage set, Schrager achieves his look at a low cost and is known for skimping on details that do not add to the overall effect (such as the Royaltons $1 Vermont instead of $8 marble). xxviii ISH rooms are also noticeably smaller that those in hotels of equivalent star rating. Without abandoning his penny-pinching

philosophy, Schrager has dramatically increased his renovation budgets, allowing him to build more spectacular settings for guestsfrom $4 million at Morgans in 1984, to the $125 million refit of the 1000-room Hudson in 2000. xxix As Schrager has taken on higher -profile projects, his distinct vision has occasionally clashed with local sensibilities. After ISH purchased the landmark Clift Hotel in San Francisco from the Four Seasons Group in 1999, local activists organized protests to prevent him from destroying the famous Redwood Room of the historic property. Experience ISH emphasis on social engineering represents a significant departure from the path of established hoteliers. While traditional hotel service foc uses on serving the needs of the individual guest, Schrager views a hotel as he would a nightclubguests are there not simply to rest and eat, but to be part of a group experience, which reinforces their membership in the stylish urban elite. I'm more of a social scientist than a businessman or a hotelier. When I sit down with Philippe, we talk about the sociology: What are people doing, what are they avoiding, where are people going, where are they movingtogether, en masse, or apart? We're not talking about fabrics or walls or design, but the whole idea of the way people behave.xxx From the outset, Schragers motto for his hotels has been you are where you sleep. Driving this message home even further, ISH populates its hotels with a staff vetted for style and physical beauty and often comprised of part-time actors and models. In 1996, Schragers redesign of the Mondrian included the dismissal of a team of Latino and Asian bellhops, who were described in a famous Schrager memo as too ethnic. (The ensuing complaint to the EEOC resulted in a million dollar settlement.) Similarly, the utilitarian aspects of a hotel (room size, professional service) are often downplayed in favor of spectacular lobbies, gardens and public spaces full of beautiful people that serve to remind guests of the cachet that comes with staying at a Schrager hotel.

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Restaurants This phenomenon is in greatest evidence at the hip restaurants and bars that are attached to each Schrager property and defended by various layers of doormen, maitre ds, and VIP lists. While hotel restaurants have typically been loss leaders designed for the guest convenience, Schragers serve as the main draw of each propertyAsia de Cuba and 44, among others, have become local hotspots and celebrity hangouts. Created, owned and managed by celebrity restaurateurs like Alain Ducasse, they not only create buzz, but also constitute profit centers in their own right. As landlord, Schrager claims to take 7 -10% of gross revenues and 50% of profits. xxxi For ISH guests, the relationship between a hotel like the Mondrian and its ber -trendy Sky Bar is pricelessa room key is the only guaranteed way to get past the bouncers. With the bars individuality comprising a major source of ISHs competitive advantage, Schrager a ctively defends them from imitators. In May 2000, Schrager filed suit against Rande Gerber, who had run three of ISHs most successful bars before leaving the organization to join Starwoods W hotel chain. Claiming that Gerber had recreated ISH bars at W properties and shared secrets with the competition, Schrager waged a public battle with the bar operator, eventually buying him out of Morgans and Skybar for $1million. xxxii Marketing Beyond their contemporary design and central locations, ISH hotels are dependent on a steady stream of celebrities to sustain the feeling of access that Schrager provides to guests. The aura of exclusivity surrounding each property has, until recently, been backed up purely by shrewd public relations, never advertising. According to Schrager, You can get a million dollars of free publicity by underwriting a party for $10,000.xxxiii Schrager hotels have played host to events for Miramax Films and MTV, and a team of publicists makes sure that the properties get mentioned in trendy periodicals and celebrity magazines alike. In addition, Schragers website offers, in exchange for an email address, a few dozen photos of celebrities mugging for the cameras at his hotels as well as a feature called The List, which offers visitors an inside view on whats hot in each Schrager city. Targeting / Pricing Schragers investment in cool translated into real value in the eyes of his target market. ISH clientele has consisted heavily of professionals from the media and entertainment industry and their hangers-on. (Originally Schrager used this fact to justify the small sizes of his guest rooms, assuming that his guests would most likely be too busy partying to notice. xxxiv) More generally, the segment attracted to a Schrager hotel is looking, if not for innovation, than for a non-generic experience. In providing an environment distinctly different from that of the predictable luxury hotel chains, Schrager hotels also excluded the features that are more or less irrelevant to its target customers, most notably meeting and conference facilities. This acted as a deterrent to group bookings and a draw for those

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who seek out uniqueness. However, the ISH deliberately avoids comparisons to traditional luxury hotels. By cutting away extraneous and costly services and focusing on image, Schrager is able to offer his customers a completely new value proposition he describes as cheap chic. ISH room rates run as high as $5000/night, but are generally priced slightly lower than luxury establishments. Schrager has also made a point of publicizing the democratic rates of the Paramount on Times Square, as well as the $95/night rooms at the Hudson (though these tiny rooms are in very limited supply and standard rooms are listed at $175).xxxv According to cheap chic, Schrager hotels discriminate on style but not on spending power thus manage to be both hip and proletarian. Growth Strategy During the flush economy of the late 1990s ISH and NorthStar actively sought to replicate the Schrager formula in different formats and on a larger scale. Schrager opened his largest hotel to date, the 1000-room Hudson in 2000 and strayed from cheap chic with the Clift in San Francisco (rates start at $260). In addition to the 1998 purchase of the Empire and Barbizon in New York for $177 million, ISH (with a loan from CSFB ) acquired the lease for the iconic St. Moritz, promising to undertake a $100 million refurbishment.xxxvi Most remarkably, in 2000-2001, ISH acquired at its first build-from -scratch property on New Yorks Astor Place, employing Dutch architect Rem Koolhaas, saying There isn't as much financial upside...but this is a chance to have an impact on the skyline of New York.xxxvii Three of the four New York projects have since been abandoned and creative differences with Koolhaas led to a replacement with architect Frank Gehry. Nonetheless, Schrager continues to look for growth opportunities. In the US, ISH is exploring sites in Las Vegas and is due to open a beachfront summer camp for adults in Santa Barbara, CA. In a dition, as the only d independent US boutique brand with a presence in Europe, ISH is looking to expand further into London as well as Paris. According to Schrager, his strategy is to go into international, 24-hour, gateway cities and do multiple hotels at various price points. xxxviii

Reaction to Competition
Schragers new focus on market-driven differentiation ultimately reflects deep changes in philosophy that have gradually taken hold at ISH, particularly in the face of increasing competition from other boutiques, most notably Starwoods W chain. (In New York, boutiques are so popular that no large hotels are due to open before 2004xxxix) As more hotels adopt a design driven approach over massmarket architecture, Schrager has found that as a competitive advanta ge, coolness, particularly in trend-obsessed cities is both substitutable and difficult to sustain. Additionally, the recession had a particularly negative effect on clients in former ISH strongholds like the media and tech sectors. Changes over the pas t 2 years include:

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Professionalization of management/staff: With the opening of the Clift, ISH installed its first human resources department and training programs. Similar moves have been taken at other properties where waits for room service were known t run into the hours. More recently, ISH o hired a new VP for the Paramount in New Yorkthe former general manager of Starwoods Phoenix resort in Arizona.
xl

Redesign/Renewal: ISH is believed to be pursuing a $400 million refinancing of existing hotels. The Paramount is undergoing renovation, including the renaming of its once-trendy Whiskey Bar. xli

Comfort over coolness: In a 2002 Wall Street Journal article, Schrager said his hotels would become more comfortable, not quite so provocative in the rooms, [with] more lighting. I'm not going to rely on having the coolest lobby or bar. Schrager was also said to be distancing himself from longtime collaborator Philippe Starck. xlii

Business services: Despite previously being labeled as the media place to stay, ISH is pursuing relationships with traditional purchasers of business travel accommodation, including Morgan Stanley. All locations currently feature meeting spaces a. Schrager: Im giving access to my hotels to some segments that I havent given access to bef ore. xliii

Price Reductions: In 2002, rooms at the Paramount were offered for $145, about half previous rates.

Advertising/Incentives: ISH launched a billboard campaign and sent 500,000 fliers to previous guests, offering a free night for two paid nights. Additionally, in March 2002, Schrager developed limited-time incentives for travel agents including 15% commissions and cash rewards.xliv

ISH has reacted to increased competition by re-focusing on service and individual customer needs, ironically taking a page f rom the playbook of the industry it once disrupted. However, as ISH increases the range of services and guest amenities, it runs the risk of cutting into the cost advantage it has traditionally held over its rivals. More importantly, efforts to attract a wider clientele threaten the delicate formula that gives Schrager hotels their aura of hipness and exclusivity, undermining the main pillar of Schragers value proposition.

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Starwood/W Hotels Starwoods Timing and Approach of Entry

Timing Starwood entered the lifestyle hotel segment because Barry Sternlicht [CEO of Starwood] wanted to create a different, cutting edge hotel lineusing physically tired assets and converting them to cater to a different type of market and outsourcing the restaurants and bars to professionals.xlv Starwood launched the W line in late 1998 with the opening of the W New York in midtown Manhattan. Designed to appeal to business travelers in the 25-49 age bracket, with incomes at or exceeding $100,000, the launch of W happily coincided with a major economic boom, helping the brand find its niche immediately. xlvi By late 1998, the market for lifestyle or boutique hotels had already been well established by entrepreneurial hoteliers. The Kimpton Group launched its first boutique hotel, the Bedford in San Franciscos Union Square, in 1981. Ian Schragers Morgans Hotel, was opened in 1984, Chip Conley started Joie de Vivre Hospitality with the launch of the rock nroll-themed Phoenix Hotel in San Francisco in 1987, and the Kimpton Hotels and Restaurants Group began the successful renovation and repositioning of old buildings into charming hotels paired with popular restaurants on the West Coast as early as 1982. xlvii The popularity of the concept, the potential for significant cost savings, and the relatively high willingness to pay, despite a more limited range of offerings and services, had all been well established. The major questions for Starwood were whether an obviously corporate hotel could draw the same stylish clientele that floc ked to offbeat boutique hotels and their popular restaurants, and how far the concept could be extended before the market for lifestyle hotels reached saturation. Value Proposition Unsurprisingly, the W hews to the classic boutique formula of small rooms and high style, charging a price premium to Starwoods upscale Westin line. Starwood played up the hotel and room amenities while being relatively honest about the hotels drawbacks. At the W New York, the first hotel launched in the W line, so-called Wish Rooms are advertised at $209 per night, only a small premium to the New York nightly average of $203,xlviii but customers are told upfront Our wish rooms are small and cozy and so is the rateget a cozy room with the ultimate queen bed, complimentary movie, and all the extras custom formulated Aveda botanical bath products, lush spastyle cotton pique W bathrobes, W Goodie Box, and much more.xlix The lobby of each W is decorated with orchids and green apples because, according to Sternlicht, orchids are not expensive

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and will last at least six months. When I first started this business, I put orchids and green apples at the front desk of a property. Suddenly, the hotel looked expensive. It only cost $800 to implement, but it changed the entire price category of the hotel.l The website also promises savvy travelers refuge in a hectic world. Calling the hotel an oasis and noting that the amenities are unparalleled, the hotels web page highlights some of the name-brand talent that gives the hotel its stylish edge. Architectural designer David Rockwell has created a tranquil sanctuary inspired by nature's elements - earth, wind, fire and water. Lose yourself in public spaces that feel privateSavor a delicious meal at Heartbeat, the hot restaurant from Drew Nieporentcreator of Nobu, Tribeca Grill and Montrachetfeaturing noted chef, Michel NischanImmerse yourself in the intimate scene at WHISKEY BLUERande Gerber's creation that redefines nightlife.li Perhaps most importantly, Starwood feels that service is what differentiates the W from a typical boutique hotel, and hence rejects the boutique label applied to Schragers hotels among others. Schrager admits I was alone in this market for 13 years. When you are the only game in town, you can get away with certain things. But, you learn that if the air conditioning does not work, it is not good for anyoneI never had a training program or a human resources department.lii Starwoods bet is that it can woo the same type of customers attracted to boutiques, but retain them through superior service. To that end, it is the first company in the hospitality industry to embark on a Six Sigma initiative, investing $17 million in training costs in 2001 alone. liii Says Sternlicht, Travelers dont want to jump from hotel to hotel. They want to rely on certain amenities like an exciting meeting place in the lobby of each W hotel and on a certain level of service liv

Starwood/Ws Financial Structure, Support and Ownership

Economics of construction and operations Starwood founded the W line to fight the growing trend towards commoditization in the hotel industry, but it still hews to a low -cost strategy whenever possible. By renovating physically tired assets rather than engaging in new construction (a notion pioneered by Schrager and other early entrepreneurs in the space), Starwood reaps significant cost savings.lv The W New York was financed for $225,000 a room, in comparison to the industry average of $400,000 for a new hotel. lvi In comparison to independents, however, Starwood can benefit from economies of scale in construction. Further economies of scale can be reaped from Starwoods large purchasing and maintenance contracts. lvii

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Does Size Matter? A W Hotel is generally far larger than the typical boutique hotel, which has approximately 150 rooms.lviii At 713 rooms, the W New York is the largest of all the W hotels controlled by Starwood; the W Chicago Lakeshore (a converted Days Inn motel) runs second with 556 rooms. lix The average W has about 311 rooms.lx While this is far larger than the average boutique hotel size of 150 rooms, it is still smaller than a typical Westin, which has over 400 rooms.lxi Starwood and Schrager have both bet, apparently with success, that customers do not highly value intimacy in a lifestyle hotel as much as design and thematic elements, warmth, and energy. (see exhibit 18 for a list of W properties) W Hotels Financial Reviewlxii Despite being a new brand, W Hotels generate higher ADR and RevPAR than the average upper upscale properties. W Hotels mainly focus on transient business customers, which constitute 70% of their overall business. Boutique hotels are highly leveraged: when the market is up, they do

especially well because they attract transient business customers, which generate the highest revenues (groups negotiate discounted rates in exchange for volume). However, in economic downturns, transient travel declines, so boutique hotels suffer more than mass-market hotels geared towards group business. Thus W hotels high operational leverage serves them well during
good market conditions, but is a burden during bad market conditions, since W hotels have a limited capacity to increase group sales when the transient market is underperforming.

For example, during 2001, RevPAR at Starwoods W hotels declined 16.4% and EBITDA declined 41.1%, whereas Starwoods overall North American owned portfolio recorded an 11.9% RevPAR decline and a 23.1 EBITDA decline. (See table below). By contrast, in 2000, W hotels were more profitable than the rest of the North American portfolio, with an EBITDA margin of 34.7% vs. 33.3% for the portfolio. While the brand is still very new and has not yet gone through a full lodging cycle, early indications are that Starwood was able to exploit the brands leverage during the economic boom: the W New York, W San Francisco, and W Los Angeles together gave a 20% ROI in 2000.

Profitability comparison of W hotels vs. Starwoods North America, 2001 RevPAR (%) W Hotel NA Owned -16.4 -11.9 EBITDA (%) -41.4 -23.1 Margin -930bp -430bp Flow -through 2.5x 1.9x

Source: Deutsche Bank, Company Information

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The W Experience
Amenities Lifestyle hotels compete vigorously on providing first-class amenities to their guests. A stylish cotton bathrobe, toiletries from Kiehls, Aveda or another small, salon-quality firm, and plush bedding are par for the course in boutique hotels, capitalizing on one of the more popular features of luxury hotels (W rooms promise guests 250 thread count sheets, goose down comforters, and Aveda bath products). In contrast to a Ritz Carlton or Four Seasons, which downplay their extensive business services beneath a veneer of old-world elegance, W offers a more visible, wired approach to service and intends to extend them further through a deal with Cisco Systems to provide extensive broadband services.lxiii Rooms have high-speed Internet access through the 27-inch TVs entertainment system, a CD player (and library of CDs available on request), coffeemaker with Ws own designer coffee blend, a high-speed port for guests who have brought their own laptops, and two phones in every room. Guests who want privacy are offered 24-hour room service from the fashionable restaurants located in the hotels, or are given priority access to tables. Because its guests are primarily business travelers, W offers a full-service business center in most lobbies and will arrange meetings and functions. lxiv Restaurants and bars One of the keystones of the W concept is to provide trendy restaurants and bars that draw in a local audience as well as hotel guests. This is a complete transformation of both the traditional upscale hotel concept of a restaurant that provides sustenance to tired guests but does not attempt to serve the type of food that would attract a clientele not staying in the hotel, and of the traditional luxury hotel concept of a formal fine dining venue where a meal will feature extremely refined service and often last three hours. To attract a stylish crowd interested in eating fashionable food, Starwood has recruited celebrity chefs to helm the restaurants in its hotels, leasing the space to boldface names like Drew Nieporent (Heartbeat in the W New York, Earth & Ocean in the W Seattle, and Icon at the W New YorkThe Court), Todd English (Olives at the W New YorkUnion Square), and Gail Deffarari (XYZ in the W San Francisco). A popular nightlife venue is also a key element of the image W is trying to portray and helps keep the hotel occupied with leisure customers on weekends. To build a collection of hip bars, W established a partnership with former model and nightlife impresario Rande Gerber in 1996, as the company planned its launch of the W New York, purchasing a 49% interest in Gerbers company Midnight Oil. lxv Gerber was leasing commercial real e state at Ian Schragers Paramount Hotel in New York when he opened a bar there called The Whiskey. His formula of tightly controlling the guest list by effectively limiting it to guests of the hotel, local VIPs, and celebrities proved extremely popular, and

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Gerber began to operate bars in other Schrager properties, including the Whiskey in the Sunset Marquis Hotel in Los Angeles. When Gerber moved to the Starwood camp, his relationship with Schrager soured and the two have engaged in a near-constant legal battle since, with Schrager buying Gerber out of some properties and an agreement that leaves Schrager the rights to name his bars Sky Bar, and Gerber Whiskey.lxvi Meeting rooms While many boutique hotels have eliminated meeting spaces as a cost-cutting measure, W uses its function space as a competitive advantage. This enables it to derive up to 20% of its business from groups. lxvii Although it cannot host the large functions many mass-market hotels regularly run, most W hotels offer several smaller meeting areas and market them to executives concerned with form as well as function. W has innovated the concept of Sensory Meetings, which promise a new way to motivate minds and get ideas flowing, using the five senses as inspiration. Mood music, aromather apy scents, retro candies, and many other special touches help set the tone. lxviii Of course, the hotels also offer their meeting spaces on weekends for weddings and parties. Catalogue and the W Store Because building a returning clientele is a key profit driver for W, it looks to invade its customers lives to the greatest extent possible. To that end, it has established an online and print catalog that it places in each guest room, allowing customers to take the W experience home with them. In addition to the W signature waffle weave cotton robe, bed linens and mattresses, and branded clothes and accessories, customers can find in the W store catalogue a juicer designed by Philippe Starck, stylish modern office accessories, and for the truly young at hear t, a skateboard. The chain also maintains a physical store in the W New York Times Square.

Starwoods Competitive Advantages

Corporate Structure W hotels benefit from significant competitive advantages by being part of the Starwood organization. The brand can exploit Starwoods resources, from website design and upkeep to access to Starwoods sales and marketing network. W also benefits from synergies with Starwoods loyalty programs: in a model reliant on repeat business, 80% of the W customer base is a member of the Starwood Preferred Guest (SPG) loyalty program.lxix This helps W retain customers, but it also brings in new customers who experience the W brand for the first time when they trade in points accrued at other Starwood brands or through purchase made with firms that allow customers to earn SPG points; the company s does not view cannibalization as a significant risk. Loyalty programs are also considered a value

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driver for business travelers in the upscale segment, although not as important as price, hotel type, or location. lxx Because W can leverage the existing Starwood corporate structure, it can be run as a relatively lean operation. Under a VP of operations, W has one director of sales and marketing, a training director, and a team of 10 workin g in design and development. This team works with various architects to keep the brand image consistent across W hotels, while each hotel remains stylistically unique, choosing upholstery and room design elements for each hotel. Cost Savings Through Economies of Scale and Scope The size of the Starwood organization and number of hotels in the chain also lower costs through significant economies of scale. All Starwood hotels share a common property management system (PMS) connected to a proprietary central reservations system (CRS), Starlink, capable of yield managing room rates across one hotel or an entire market (see Exhibit 19 The hotel business transactional process reserving a room). A seamless connection between a hotels PMS and the chains CRS offers hotels the ability to coordinate and yield manage individual and group sales reservations. These reservations can come through travel agents accessing any one of the four centralized Global Distribution Systems (GDS), websites (both Starwoods proprietary website and unaffiliated travel websites, which hit Starlink via the GDS) and telephone. By contrast, independent hotels cannot afford a customized CRS, while Ian Schrager only implemented a standardized PMS across his hotels in early 2003. lxxi Independent hotels and small chains must find a way to link their PMS (or CRS if they have one) to a switch providing access to the four GDS systems; this is often accomplished by joining a marketing group or signing up with a GDS representative such as Utell, Unirez, or Lexington Reservation Systems, all of which charge significant fees on top of the GDS feesfor each reservation or sometimes for each night of stay. Finally, Starwood benefits from pricing and sales information from its other hotels in each Ws market, information not available to independent hotels and small chains. W also benefits from Starwoods economies of scope, gaining advantaged pricing on maintenance contracts and supplies as part of a large family of brands. In contrast, independent hotels and small chains must purchase in smaller quantities and pay higher prices. Starwood is also able to devote more resources to improving its supply chain management than a small chain or independent hotel, seeking out and achieving cost savings in its purchases of items including linens, cleaning supplies, telecommunications, and IT infrastructure.

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Quality of Service All W Hotels are tightly controlled by Starwood (e.g., owned, leased, part of a consolidated joint venture, or managed by Starwood),
lxxii

which gives the company a far greater ability to control the

level and consistency of service than it has for franchised hotels managed by third parties. While Starwood franchises its Westin, Sheraton and Four Points by Sheraton brands, it is not pursuing a franchise strategy for W.lxxiii Starwood defines the service philosophy for the W brand as follows: W is a fresh alternative combining the personality and style of independent hotels with whatever you want, whenever you want it service.lxxiv Based on industry reviews, it has apparently succeeded in this strategy: Business Travel News ranked W Hotels first in the upper-upscale category for 2001, rising from fifth place the previous year, and beating long-established competition from Loews, Le Meridien, and Inter-Continental. lxxv Cond Nast Traveler Magazine named three W hotels to its 2002 Gold List, consisting of the magazine readerships favorite hotels, resorts and cruise lines worldwide. lxxvi In comparison to independent hotels, W benefits from the ability to train its staff using techniques that have been established and rolled out across the entire Starwood organization, such as its $17-plus million Six Sigma initiative. This is especially critical in a segment of the industry that suffers higher turnover than industry average; because lifestyle hotels tend to recruit young, trendy, good-looking staff, there is a high risk of losing that staff to more rewarding opportunities in the fields of modeling or acting. lxxvii Locations The W model is to build hotels in major urban destinations. These destinations cement the brands status as a business hotel; to boost its leisure bookings, the line uses a heavy promotional push to entice out-of-town and even local guests for weekend stays. Efforts include advertising (including a major campaign in national magazines and the Wall Street Journal for late winter/spring 2003) and targeted promotions often bundling added-value services such as spa treatments, meals, parking, spa discounts, flowers, and champagne with rooms at special prices. Urban locations were hardest-hit by the aftermath of the September 11th attacks on the travel industry. However, Starwood considers that the worst is over on this front and that the companys urban focus leaves it levered to the busines s travel recovery.lxxviii Willingness To Pay The W brand appears to be a good example of value innovation: Starwood has eliminated features and services that are not important to customers and accentuated or implemented services and features that add value to ts base. A specific example might be its popular Wired promotion, offering guests i unlimited high speed Internet access, unlimited local, toll free, and domestic long distance telephone

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calls, and a keepsake mouse pad, in addition to the room, which was based on customer requests. Key features such as fitness centers and the Ws signature Away Spa are accentuated, while expensive elements not highly valued by customers, such as room space, exterior balconies, and new construction, are eliminated. Branded hotels also offer an enhanced image of security in comparison to independent hotels, for which both business and leisure travelers are willing to pay a premium: 10.75% for leisure travelers, and 7.73% for business travelers.lxxix E-strategy Internet bookings are a significant opportunity for hotels, because they eliminate all fees normally paid to GDS companies and outsourced customer service telephone operators, as well as travel agent commissions. Thus Starwood has made a significant investment in its hotel websites, as have many of its competitors. This effort appears to have begun to pay dividends: the company has experienced a 60% increase in web bookings over the past year.lxxx While independent hoteliers are also investing in allowing online bookings, many do not have the capability of eliminating third parties from the transaction, and still have to pay GDS fees on any sales booked over the Internet. For example, Ian Schragers site is powered by www.tabletbookings.com, and uses Pegasus to link to the GDS. Marketing and Public Relations W is able to leverage Starwoods significant investments in marketing in ways not available to independent hotels and small chains. Starwood has dedicated significant resources to its hotel

websites. W plans to roll out a new web design in mid-March, and envisions a constantly evolving web presence. lxxxi However, because W seeks a significantly different image than the other Starwood brands, and relies heavily on PR to maint ain its trendy image, it does not rely on Starwoods internal PR department and instead pays a fee to an outside company. lxxxii Growth Strategy and opportunities A new location for a W hotel must meet several criteria. First, the location itself must serve the brands image: for example, the W Atlanta (in Buckhead) and the W Suites in Newark, CA (Silicon Valley) are Ws only suburban locations. If a location is suitably urban and hip, the market must still be able to support a hotel at a $50 price point premium to a Westin and an even greater premium to a Sheraton. Starwood will not open a W in a market that it believes cannot sustain greater than a $30 premium to a Westin. lxxxiii The W brand accounted for 6% of Starwoods EBITDA in 2001, when it declined more heavily than other Starwood brands because its distribution is weighted towards markets profoundly affected by the business downturn in 2001. Starwood intends to grow the brand aggressively over the next five years,

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increasing the total number of W hotels to 50 by 2007. lxxxiv Starwood owns 22 properties that do not fly the flag of one of the Starwood brands and thus appear to be ripe for conversion into W branded hotels. lxxxv Long term strategy Starwood views W as a growth vehicle, feeling the brand strategy has been successful and that the line has earned its place in the Starwood portfolio. Developers are excited to partner with Starwood in a time of decreasing capital investment in the hotel industry. One question mark still to be resolved is how the capital replacement cycle economics will play out for the brand. While larger Starwood assets, such as Sheraton hotels, tend to be renovated on a 20-30 year cycle, W's upper upscale segment, fashion-conscious target market, and reliance on design elements will require more frequent renovations. At this point, the existing W hotels are too new to estimate the economic impact on the life of the capital invested in the brand. Of course, this capital replenishment issue would also affect independent boutique hotels as well as W hotels.

Boutique Growing Pains

Sensing a market opportunity, others soon jumped onto the bandwagon. In 2001, Marriott announced it was repositioning its Renaissance brand as a chic boutique chain, stating We figure 30% of the market out there is attracted to the boutique, sort of eclectic, sort of different, give-me-a-surprise kind of hotels.lxxxvi Marriott has also made a combined $140 million investment with Italian jeweler Bulgari to launch a line of boutique hotels in Europe. lxxxvii This gold-rush m entality may have created a surplus of boutique hotels in the market. After the events of September 11th, 2001, which left the travel industry reeling, many boutique hotels were struggling to survive. Still relatively new, they were not yet as competitiv e as seasoned players, and without significant meeting space (a costly use of space eliminated in many boutique hotels), they had fewer tools to drive demand during a downturn. lxxxviii Service also became a differentiator: because staff at a boutique hotel is often chosen for looks, style, and energy, training can be spotty and staff may neglect to maintain a deferential service attitude under high-pressured situations. Given the ego-driven nature of the typical boutique hotel client, keeping staff more exci ed by a dreamed-of career in modeling or acting than t their current job interested in what the hotel is, is a challenge boutique hotels cannot ignore if they want to survive. lxxxix Perhaps because of this backlash effect, W Hotels has attempted to categorize their product as lifestyle hotels rather than boutiques, with a stronger emphasis on service as a differentiating factor as well as the now-expected design, chic restaurants and bars, and individual style.xc Says Lisa Zandee of W, We have never used the term boutiquethough others have used it of us. People in the US are questioning the longevity of boutique hotels because what happens, after they come into fashion, if a

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lot more open? We are trying to make our brand last by not making it too trendy. We dont want design that will be out of date tomorrow.xci The events of September 11 hit urban, upscale hotels extremely hard, as business travel declined and a shaken customer base began seeking out comfort and solace over a hip, trendy lobby scene. Given the state of the economy, [boutique hotels] became not only less appropriate (but excessive), notes Bjorn Hanson of PwC.xcii Says Chip Conley of Joie de Vivre, a 22-hotel chain based in San Francisco, Were in the era of the post-hip boutique hotel. Travelers have had enough of hotels that are all about the scene and are moving toward those that are stylish, comfortable and offer something they can relate to. xciii We have to move away from positioning as a status symbol and move to positioning as a comfortable sanctuary, agrees Jim Berra, Starwoods vice president of customer loyalty. xciv Despite the volatility of the segment, Starwood has rushed to open new W hotels (17 are open to date, with five in New York City alone, and launches are planned for Mexico City and Seoul later this year), calling the brand a runaway success.xcv Indeed, the line experienced an increase in revenue per available room night (RevPAR) of 30%, from $142 to $182, between fourth quarter 2000 and the same period a year before. xcvi However, because the hotels are primarily located in cities that suffered major downturns after September 11, the average daily rate for 2001 suffered a 23% decrease from the prior year, from $245.83 to $189.76. xcvii After September 11, urban hotels in general saw occupancy rates decline from 68.2% in 2000 to 56.2% in early 2002; boutique hotels showed a similar pattern with rates declining from 73.7% to 55.6% during the same period, according to Smith Travel Research. However, boutiques have been rebounding more slowly than other segments, and theyre probably going to face an uphill struggle for the foreseeable future, according to Smith Travel Research analyst Bobby Bowers.xcviii Nonetheless, the W brand saw 14.2% RevPAR increase in fourth quarter 2002 over the same period a year earlier. xcix

Conclusion: Is Ian Schragers approach to hotels sustainable? Will W outperform ISH?

Arguably, Ian Schrager Hotels used value innovation to change many contextual elements of the upscale hotel business model. Primarily, Schrager altered the scope of competition by offering unique, design-led customer experiences. Schrager hotels reintroduced creative differentiation to an industry that was accustomed to competing solely on the ability to provide the same array of standar d luxuries at the lowest cost. Additionally, he revived an element of turn-of-the century grand hotels by developing restaurants and bars that functioned as local draws and profit centers. However, the entry of Starwoods W proved that a hotel can also be successful by adopting selected aspects of the boutique formula while highlighting comfort and service. Schragers recent move to embrace traditional elements of customer focus (improved customer service, implementing advertising and business services) confirms that service is a key willingness to pay factor for many segments of

30

the increasingly heterogeneous boutique hotel customer base. Industry observers note that Schrager may be alienating his core clientele by allowing too much of the mass market behind his velvet rope, leaving himself stuck in the middle. The tastes of this trend-setting group are notoriously fickle, particularly in the face of intense competition in cities like New York. By attempting to turn hotels into fashion items, forgetting that fashion inevitably fades, Schrager may find sustainable profitability elusive. Furthermore, Schrager will be required to invest frequently in renovating his properties if he intends to keep them fresh and buzzworthy.

Ian Schragers main opportunity may be to retrench to serving the style elite that make up his core customer base, and using his current European footprint to be the first mover in cities outside the US with no existing boutique presence. However, his independent status may prevent him from gaining access to the capital he needs to pursue necessary expansion, particularly in a downturn. Starwood, on the other hand, closed a new $1.3 billion senior credit facility in October 2002, leaving it with $600 million of capacity after refinancing its existing debt, and claims that developers are excited to partner with the company to develop W hotels in a time of decreasing capital investment in the hotel industry. c ISHs global ambitions run a serious risk of being preempted by Starwo or by European od entrepreneurs and hoteliers with deeper local knowledge and pockets. The high leverage of lifestyle hotels has led them to suffer heavily from the current economy in their core urban markets. However, the W brand is better positioned than most to survive the downturn. W can leverage Starwoods established sales organization and extensive contacts with corporate planners to stimulate contracted business travel towards W hotels as needed. On the other hand, independent boutique hotels, including Schrager's properties, do not have the meeting spaces, sales organizations, or relationships to attract group business in times of economic downturn. As a result, hoteliers such as Schrager are forced to turn to less-desirable sources of transient guests such as Expedia/Travelscape and Hotels.com. These websites provide hotels with large volumes of guests, but at a high cost: hoteliers must set aside blocks of rooms at low net rates, pay high distribution costs, and potentially suffer brand dilution in the case of image-sensitive hotels like Schrager's. While boutique hotels in general must wait for sunnier economic times to thrive again, Starwood appears to have built a sustainable competitive advantage over first-mover Ian Schrager that holds in both good times and bad. Schrager is rightly credited with popularizing the boutique concept, but W has found a way to bring the cachet of boutique hotels to a wider audience, without damaging the brands credibility. Schrager may well survive as a niche player, but W is better positioned to succeed in the long run. Thanks to its superior corporate organization, economies of scale, and quality of service, the W brand is poised to be more than just a passing fad in the hotel industry.

31

Pictures W Hotels

ci

cii

32

ciii

civ

cv

33

cvi

cvii

cviii

34

Ian Schrager Hotels

cix

cx

cxi

35

cxii

36

Exhibits
Exhibit 1:

US Hotel Industry Short History in numbers

120 100 80 60 40 20 0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2,000 1,000 0
Sales (US$ billion) - lhs Average Room Rate (US$) - lhs Occupancy (%) - lhs Total hotel rooms (in thous.) - rhs

5,000 4,000 3,000

Source: American Hotel and Lodging Association

Exhibit 2:

US Lodging Demand and GDP 1968 -2001

Source: PricewaterhouseCoopers, Smith Travel Research, Deutsche Bank

37

Exhibit 3:

US Rooms under Construction Versus Existing Supply as of July 2002

Number of Rooms Chain Scale Upper Upper Scale Upscale Mid Scale w/F&B Mid Scale w/o F&B Economy Unaffiliated In construction 26,504 22,189 4,364 18,586 5,243 25,803 102,689 % Existing Room Base 4.4% 6.9% 0.7% 3.2% 0.7% 2.0% 2.4% Existing Room Base 605,795 323,430 630,162 577,508 778,890 1,305,034 4,220,819

TOTAL

Source: Smith Travel Research and Deutsche Bank Securities Inc., estimates

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Exhibit 4: Timeline of the Hotel Industry

1900 - A typical first-class hotel offers steam heat, gas burners, electric call bells, baths and closets on all floors, billiard and sample rooms, barbershops, and liveries. The Lenox H offered "fireproof lodging, unexcelled cuisine, a shower bath, roof garden, and otel American/European lodging plans starting at $2." 1904 - New York City's St. Regis Hotel provides individually controlled heating and cooling units in each guestroom. 1908 - Gideons International places their first Bible in the Superior Hotel in Montana. The Hotel Statler chain begins in Buffalo. All guestrooms have private baths, full-length mirrors, telephones, and built-in radios, serving as the model for hotel constr uction for the next 40 years. 1910 - The American Hotel Assn. is formed for the "apprehension and punishment to the fullest extent of the law, of professional deadbeats, check forgers, dishonest and undesirable employees, crooks of all descriptions and such other matters." The lodging industry consists almost entirely of hotels situated in urban centers and resorts near the principal vacation destinations. Electricity is beginning to be installed in new hotels for cooking purposes, as well as for lighting. However, most hotels place candlesticks, new candles, and matches in every roomelectric light bulb or not. 1916 - The Federal Road Aid Act spawns a new segment of the lodging industry. 1919 - Conrad Hilton purchases his first hotel, The Mobley, in Cisco, Texas. 1920s - Golden Age 1920 - Prohibition begins. 1922 - The Treadway Company has some of the first management contracts on small college inns. The first collegiate program in hotel and restaurant management is initiated at Cornell University by the American Hotel Association. 1925 - The first roadside "motel" opens in San Luis Obispo, Calif., for $2.50 a night. 1927 - The Hotel Statler in Boston becomes the first hotel with radio reception; rooms are equipped with individual headsets to receive broadcasts from a central control room. The Huntington Hotel in Calif. installs the first Olympic-size hotel swimming pool. 1929 - Western Hotels, now Westin, starts with 17 hotels in the Pacific Northwest and establishes the first U.S. hotel management company. The Oakland Airport Hotel becomes the first of its kind in the country. 1930s - The Great Depression 1930 - Four out of five hotels in the United States go into receivership. The standard travel agent commission is 10 percent. 1933 - Due to the Great Depression, hotels post the lowest average occupancy rate on record, 51 percent. Construction grinds to a halt. 1934 - The Hotel Statler in Detroit is the first to have a central system to "air condition" every public room. 1937 - Membership in the Waiters and Bartenders National Union, which encompasses hotel employees, exceeds 200,000. 1939 - Quality Courts, later Choice Hotels International, is formed by seven motel operators as a nonprofit referral system. 1940s - WWII and Recovery 1940 - No materials for expansion; 93% occupancy. After the Depression, recovery awaits the outcome of the World War II. Air conditioning and "air cooling" become prevalent. 1945 - Sheraton is the first hotel corporation to be listed on the New York Stock E xchange. Travelodge becomes the first economy-lodging corporation. 1946 - Recovery at last. Occupancy reaches the highest-ever rate, 93 percent. Best Western is founded by M.K. Guertin and 54 friends. The first casino hotel, the Flamingo, debuts in Las Vegas. Westin debuts first guest credit card. Larry and Bob Tisch purchase Laurel-in-the Pines, Lakewood, N.J., which evolved into Loews Hotels. 1947 - Westin establishes Hoteltype, the first hotel reservation system. New York City's Roosevelt Hotel installs television sets in all guestrooms. 1949 - Hilton becomes the first international hotel chain with the opening of the Caribe Hilton in San Juan, Puerto Rico. 1950s - The Growth of Motel Chains 1951 - The American Hotel Institute, later to be renamed the Educational Institute, is launched. Hilton is the first chain to install television sets in all guestrooms. 1952 - Less than a year after Congress approves the development of an interstate highway system, Kemmons Wilson starts Holiday Inns. Kemmons Wilson opens his first Holiday Inn in Memphis, Tenn., named after a Bing Crosby movie. The far -reaching impact of the interstate highway system on travel patterns, which meant boom and opportunity for many, and decline or bust for others. 1953 - AHA buys the Universal Credit Card. The American Hotel Foundation, a subsidiary of AHA, is founded. 1954 - Howard Dearing Johnson initiates the first lodging franchise, a motor lodge in Savannah, Ga. Conrad Hilton's purchase of the Statler Hotel Company for $111 million is largest real -estate transaction in history. An inn in Flagstaff, Ariz., is the first in a series of "motor hotels" forming Ramada, a Spanish word meaning "a shaded resting place." Mid-1950s - Atlas Hotels develops the first in-room coffee concept. 1957 - J.W. Marriott opens his first hotel, the Twin Bridges Marriott Motor Hotel in Arlington, Va., and Jay Pritzker buys his first hotel, The Hyatt House, located outside the Los Angeles Airport. Hilton offers direct-dial telephone service. 1958 - AHA sells license for the Universal Travel Card to American Express. Sheraton introduces Reservatron, the industry's first automated electronic reservations system, and the first toll-free reservation number. Omni Hotels, originally Dunfey Hotels, is founded. 1960s - The Growth of Hotel Chains Early 1960s - Siegas introduces the first true minibar 1962 - Motel 6, the forerunner of budget brands opens. 1964 - Travelodge debuts wheelchair -accessible rooms. 1965 - The Highway Beautification Act, which ultimately changed highway advertising, an important marketing lifeline for roadside lodgings. AT&T offers a direct -reservation service featuring raid dialing; 300 hotels sign on with Guaranteed Reservations; Holidex by IBM is installed in Holiday Inns; Univac' s Teleman Unitel system makes up to 120 reservations per hour. 1966 - Inter-Continental introduces retractable drying lines in guest showers, business lounges, ice and vending machines in guest corridors, and street entrances for hotel restaurants. 1967 - The Atlanta Hyatt Regency opens, featuring a 21-story atrium and changing the course of upscale hotel design. Hyatt Hotels Corporation splits into a real -estate holding company. 1969 - Westin is the first hotel chai n to implement 24-hour room service. 1970s - The Growth of Franchising The budget -hotel boom, little more than another new idea in 1966, was a full -blown trend by the early 1970s. Increased momentum in the development of chains, which represented less than 10% of the motel population in 1966, was an estimated 40% by 1975. The destabilizing jolt of the energy problem --then crisis--of the early 1970s, left in its wake an erratic economy over most of the remainder of the decade. Tourism industry is hard hit.

39

Tourism industry is hard hit. 1970 - Hilton becomes the first billion-dollar lodging and food service company and the first to enter the Las Vegas market. 1973 - The Sheraton-Anaheim is the first to offer free in-room movies. 1974 - The energy crisis hits the industry - hotels dim exterior signs, cut heat to unoccupied rooms, and ask guests to conserve electricity. 1975 - Four Seasons is the first hotel company to offer in-room amenities such as name -brand shampoo. Hyatt introduces an industry first when it opens its Regency Club, a concierge club level that provides the ultimate in VIP services. Cecil B. Day hands out wooden nickels to guests over 50, establishing the first seniors program. 1976 - Two Florida hotels are the first to offer HBO in guestrooms. 1977 - Showtime and The Movie Channel debut in hotels. 1978 - Best Western has 2,000 affiliates; Holiday Inns, 1,700; Super 8, 71; and Budget Host, 25. 1980s - Prosperity and Recession Reagan administration tax law encourages investment in construction as a tax shelter and spurs the boom of the century. Expansion of Bed and Breakfast concept in North America. Steady advances in computerization and systems management that replace more rudimentary procedures and leads to improvements in every area of operations, from back-of-the-house functions to central -reservation systems. Massive overbuilding of hotel accommodations result in a room surplus and plunging occupancy rates. 1981 - Two of the first boutique hotels in the world open their doors to the public: The Blakes Hotel in London and the Bedford in San Francisco. 1983 - Westin is the first major hotel company to offer reservations and checkout using major credit cards. VingCard invents the optical electronic key card. 1984 Ian Schrage opens his first boutique hotel in New York City: the Morgans Hotel. Holiday Inn is the first to offer a centralized r travel agent commission plan. Choice Hotels introduces the concept of market segmentation. Choice Hotels offers no -smoking rooms. Hampton Inns is the first to offer a set of amenities. Holiday Inn debuts Embassy Suites Hotels, the first nationwide all-suite hotel chain, in Overland Park, Kan. 1986 - Teledex Corporation introduces the first telephone designed specifically for hotel guestrooms. Days Inn provides an interactive reservation capability connecting all hotels. 1988 - Extended stay segment introduced with Marriott's Residence Inns and Holiday Corporation's Homewood Suites. 1989 - Hyatt introduces a chain wide kids program for ages 3-12 and a business center at the Hyatt Regency Chicago. Hampton Inns is the first hotel chain to introduce the 100 percent satisfaction guarantee. 1990s - Recession and Recovery By the early 1990s, expansion ends with more changes in the US tax code, worldwide recession and the Persian Gulf War. These events lead to a 3-year period of slumping occupancies and rates. New construction virtually stops as financing becomes scarce. These years are followed by the recovery of the hotel industry. Full-service, city center hotels become the linchpin sought by municipal governments for attracting travelers back to city centers. New industry strategies include: Niche marketing / market segmentation, an increase in central reservation systems, and a stronger emphasis on quality of service. Between 1986 and 1992, the US hotel industry lost approximately $14 billion. Overcapacity plagued the industry for most of the late 1980's and early 1990's. Most of these operators cite operating cost controls, higher room rates, and restructuring of real estate debt as measures taken towards renewed profitability. 1990 - Loews Hotels' Good Neighbor Policy becomes the industry's first and most comprehensive community outreach program. 1991 - Westin is the first hotel chain to provide in-room voice mail. Industry sees record losses, 61.8 percent. 1992 - Industry breaks even financially after six consecutive years of losses. 1993 - Radisson Hotels Worldwide is the first to introduce business-class rooms. 1994 - First online hotel catalog debuts - TravelWeb.com. Promus and Hyatt Hotels are the first chains to establish a site on the Internet. 1995 - Choice Hotels International and Promus become the first companies to offer guests "real -time" access to its central reservations syste Choice and Holiday Inn are the first to introduce online booking capability. m. 1996 - Best Western celebrates its 50th anniversary, making it the oldest continually operating brand. 1999 - Choice Hotels International is the first chain to test making in-room PCs a standard amenity for guests. Starwood Hotels & Resorts takes the boutique segment mainstream with the opening of its W brand. 2000s - New Opportunities Technology, Mergers and Acquisitions: International Expansion, Demographic Changes: Age, Cultural Diversity, Eco -Tourism 2000 - Hilton unveils plans for the first luxury hotel in space.

40

Exhibit 5: US Room Revenue by Chain Scale 2001 Segment Upper Upper Scale Upscale Mid Scale w/F&B Mid Scale w/o F&B Economy Independent TOTAL Rooms 595,658 318,497 637,663 568,039 777,018 1,276,551 4,173,426 % Total 14.3 7.6 15.3 13.6 18.6 30.6 100.0 Room Revenue 20,397 7,010 9,692 8,447 7,406 23,601 76,553 % Total 26.6 9.2 12.7 11.0 9.7 30.8 100.0

Source: Smith Travel Resear ch and Deutsche Bank Securities Inc., estimates

Exhibit 6: US hotels by size

150-299 rooms 21% 300-500 rooms 10% >70 rooms 23% Over 500 rooms 11% Highway 32% Urban 16%

US hotels by location
Resort 12% Airport 11%
Suburban 29%

75-149 rooms 35%

Exhibit 7:

US Hotel Industry : Market Share by Major Player as of July 02

Marriott Hilton Int'l Hotels 8% 8% Starwood 3% Six Continent s 8% Cendant 12%

Others 61%

Source: Smith Travel Research, Deutsche Bank

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Exhibit 8:

Ian Schrager Hotels Five Forces

Bargaining Power of Suppliers: MEDIUM Limited access to GDS - need to use a marketing group or GDS representative.

Threat of New Entrants: HIGH Low variable costs once property is up and running Customer heterogeneity can be addressed by specialty/themed hotels Low property costs for run-down buildings that will be renovated Large chains can make small bets on a boutique hotel Use of viral marketing (peer recommendations) BUT, High property costs for prime location High design costs

Bargaining Power of Buyers: LOW High willingness-to-pay for in, hip hotels BUT No loyalty program Low switching costs

Rivalry Among Existing Players: HIGH Little differentiation within quality types Newness and hipness of hotel needs to be constantly maintained fewer added services offered Some price-based competition PR-based competition BUT, Very high growth of boutique hotel market Location-specific nature of hotels

Threat of Substitute Products: HIGH Luxury Hotels Resorts Other hotels

Exhibit 9:

W Hotels Five Forces

Bargaining Power of Suppliers: LOW Own reservation system - direct link (STARLINK - from Starwood) Use leverage of Starwood for purchasing

Threat of New Entrants: MEDIUM Low variable costs once property is up and running Customer heterogeneity can be addressed by specialty/themed hotels Low property costs for run-down buildings that will be renovated Boutique hotels can be added one by one - no need for mass expansion before profits can be had BUT, High property costs for prime location High design costs High marketing expenditures Rivalry Among Existing Players: HIGH Little differentiation within quality types Newness and hipness of hotel needs to be constantly maintained Services offered (business conference rooms, added 9/11 security) Some price-based competition Economies of scope BUT, Very high growth of boutique hotel market Location-specific nature of hotels

Bargaining Power of Buyers: LOW High willingness-to-pay for in, hip hotels Loyalty program (Starwood) - lock -in BUT Low switching costs

Threat of Substitute Products: HIGH Luxury Hotels Resorts Other hotels Potential risk of cannibalization from other Starwood brands (Westin)

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Exhibit 10:

What Type of Innovation Is the Boutique Hotel?

Market Innovation Enhance Enhance Market Knowledge Destroy Boutique Hotels Destroy

Exhibit 11:

How Disruptive Are Boutique Hotels?

Technology Knowledge/Links Conserve Disrupt Market Knowledge/ Links Conserve
Boutique Hotels (Niche Creation)

Disrupt

43

Exhibit 12:

Building of Alliances Between Hotels and Bars/Restaurants

Individual Alliance Competence Leverage Competence Acquisition Boutique Hotels Networks

Exhibit 13:

Actions for Value Innovation

Create Valuable New Factors
Feel and Design (Architecture) Themed Hotel - New buyer Fashionable Staff target Inclusion on the list - Strong draw from restaurant and bar Technology in room Hip restaurant Hip bar Intimacy (small hotel)

Raise on Primary Factors

Customer Benefit
Which factors are key benefit drivers but often compromised?

Are there entirely new factors that deliver customers a quantum leap in value?

Are there factors that the industry takes for granted but which dont add value?

Which factors are necessary but not to be overdone?

Eliminate Tertiary Factors

Cost
Shops in Hotel Luxurious fixtures (Marble) Multiple Restaurants Multiple Lobbies - Eliminate some luxury - reduce size of rooms and lobbies (more rooms in a smaller area) Business meeting space Size of room Size of lobby Depersonalization

Reduce Secondary Factors

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Exhibit 14:

Value Curve for Boutique Hotels

High

Boutique Hotel
Relative Offering Level

Luxury Hotel

Low
Ent (Ba ertainm rs) ent Arc Ae hitect sth etic ural s Ro om Siz e Re Are ceptio n a Be dQ ual ity In Tec room hno log y The me Co nci erg e Am eni ties Pric e

Upscale Hotel (Sheraton)

Sho ps Loc atio n Eat Fac ing iliti es Me Spa eting ce Ser vic e

Key elements of product, service and delivery

Exhibit 15:

Preference Structure
Functional Attribute: Level of Targeted Service

Luxury Hotel
Luxury

Boutique Hotel

Standard

Mass-Market Hotel
Upscale and Older Upscale and Younger Average and All ages

Functional Attribute: Type of Consumer

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Exhibit 16:

Innovation Diffusion for Boutique Hotels

Early and Late Majority

Adopters Early Adopters Innovators

Time

Exhibit 17:

Competitive Advantage (WTP vs. Cost)

Luxury Hotel Boutique Hotel Mass-Market Hotel

WTP

Price

Cost

46

Exhibit 18:

Exhibit 19:

The Hotel business Transactional Process - Reserving a room

Hotel Website

Telephone Customer Travel Agent

$ - Outsourced

Customer Reservation System (CRS)

Hotel

Global Distribution System (GDS) Unaffiliated Travel Website $ - lower than by phone

$ - Switch Fixed cost for W variable (per use) fee for Ian Schrager

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References:
i

American Hotel and Lodging Association, History of lodging, www.ahma.com Deutsche Bank, Lodging Industry Overview , August 2002, ABN Amro, Hotel & Leisure Direction 2003, Jan 2003, Ernst&Young, 2002 National Lodging Forecast iii http//:www.tacnet.com/scripts/hotel.cfm iv PriceWaterhouseCoopers Research Briefing, October 2001 v Hilton Hotels Website vi Marriott Hotels Website vii Anhar, Lucienne, The Definition of Boutique Hotels. Hospitality Net, December 13, 2001. viii Ibid. ix Ibid. x Gordon, Meryl, The Cool War: Ian Schrager vs. His Imitators, The New York Times , May 27, 2001. xi Dunlap, David W., From Planet Hollyw ood to a Hotel W in Gray, The New York Times , Section B, p. 7, August 29, 2001. xii Anhar, The Definition of Boutique Hotels. Hospitality Net, December 13, 2001. xiii DaRosa, Alison, Upscale Hotels Go Hip Instead of Traditional, The San Diego Union-Tribune, Travel, p. D-3, September 9, 2001. xiv OConnor, Stefani C., (citing Bjorn Hanson, head of PriceWaterhouseCoopers hospitality and leisure group), Boutique Hotels, A Difficult Segment to Define,www.hotelbusiness.com, January 21, 2001. xv Ibid. xvi Ian Schragers Vision Statement, p. 1, www.ianschrager.com. xvii Bray, Roger, Chains Awake to Designer Trend: Boutique Hotels, Financial Times, FT Report: Business Trav el, September 26, 2002, p. 2. xviii Anhar, The Definition of Boutique Hotels. Hospitality Net, December 13, 2001. xix http://www.starwood.com/whotels/about/history.html xx Tomkins, Richard, Schrager and NorthStar join forces, The Financial Times , March 19, 1998 Gordon, Meryl, The Cool War: Ian Schrager vs. His Imitators, The New York Times , May 27, 2001 xxi Parkes, Christopher, Cool hotelier remodels faade, The Times of London, October 28, 1996 (at the Mondrian and Londons Sanderson respectively). xxii Ibid. xxiii Tomkins, Richard, Schrager and NorthStar join forces, The Financial Times , March 19, 1998 xxiv NorthStar corporate website, www.northcap.com xxv Billig, Michael, Schrager Hanging For Sale Sign on New Yorks Empire Hotel, www.HotelBusiness.com, June 20, 2002 xxvi Gordon, Meryl, The Cool War: Ian Schrager vs. His Imitators, The New York Times , May 27, 2001 xxvii Ibid. xxviii Ibid. xxix Ibid., Arden-Smith, Tara, The man whos shaking up the hotel scene, The Boston Globe, June 10, 2001 xxx Ibid. xxxi Gordon, Meryl, The Cool War: Ian Schrager vs. His Imitators, The New York Times , May 27, 2001 xxxii Fink, Mitchell; Rubin, Lauren, Schrager vs. Gerber: Its a barroom brawl, New York Daily News, May 11, 2000 xxxiii Gordon, Meryl, The Cool War: Ian Schrager vs. His Imitators, The New York Times , May 27, 2001 xxxiv Gordon, Meryl, The Cool War: Ian Schrager vs. His Imitators, The New York Times , May 27, 2001 xxxv Arden-Smith, Tara, The man whos shaking up the hotel scene, The Boston Globe, June 10, 2001 xxxvi Grant, Peter, In Need of Financing, New York Hotel Developer Feels Trump's Pressure, New York Daily News, July 13, 1999 xxxvii Gordon, Meryl, The Cool War: Ian Schrager vs. His Imitators, The New York Times , May 27, 2001 xxxviii Interview with Ian Schrager in Travel Agent, March 11 2002 xxxix Murray, Sarah, Boom time for New York hotels, The Financial Times, January 14, 2003 xl McMullen, Shannon, New GM at NYCs paramount to oversee redesign, www.HotelBusiness.com, February 27, 2003 xli Billig, Michael, Major re-fi in works for Schrager hotels, www.hotelbusiness.com, January 17, 2003 xlii Binkley, Bloom Fades at Boutique Hotels, The Wall Street Journal, cited in The Chicago Sun-Times, Travel Section, p. 6, March 17, 2002. xliii Ibid. xliv Interview with Ian Schrager in Travel Agent, March 11 2002 xlv Conversation with Robert Koren, VP of Operations, W Hotels, on Thursday, February 6, 2003.
ii

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xlvi

Ibid. http://www.kimptongroup.com/about_concepts.html xlviii Blair, Jayson, Not the Best of Times, But Manhattan Hotels See Encouraging Signs, The New York Times, Section B, p. 1, March 28, 2002. xlix http://www.starwood.com/whotels/search/hotel_detail.html?propertyID=97502 l Shinn, So -Chung, Starry Might: Starwood Hotels and Resorts Invests in Design to Create Style, Attitude, and Brand Distinction in its Six International Hotel Brands, Interior Design, Starwood Hospitality Supplement, March 27, 2001, p. S10. li Ibid. lii Scoviak-Lerner, Mary, Challenging the Chains, Business and Management Practices, Vol. 36, No. 1, p. 5054. liii Starwood 2001 Annual Report, p. 4. liv Sullivan, Aline, Future Face of Hotels: Industry Looks For Right Formulas, International Herald Tribune, Special Report, p. 9. lv Conversation with Robert Koren, VP of Operations, W Hotels, on Thursday, February 6, 2003. lvi Seitz, Patrick, How Dell, Starwood and Teva Fight, Win in Commodity-Priced Business, Investors Business Daily, Section A, p. 1, May 4, 2001. lvii Conversation with Robert Koren, VP of Operations, W Hotels, on Thursday, February 6, 2003. lviii Anhar, The Definition of Boutique Hotels. Hospitality Net, December 13, 2001. lix Starwood Hotels and Resorts Worldwide, Inc. Detail list of Hotels and Rooms Owned, Leased and Consolidated Joint Venture, as of June 30, 2002, p.5-6. The numbers quoted do not reflect franchised properties. lx Brown, Ron, Hospitality Conference Presentation, November 2002, www.starwood.com/corporate/investor_relations.html, slide 2. lxi Ibid. lxii Deutsche Bank, Starwood Hotels & Resorts, August 2002 lxiii Starwood Announces Strategic Relationship With Cisco Systems to Deliver Secure, High-Speed Internet Access and Next -Generation Services to Hotel Guests, Business Wire, March 5, 2001. lxiv http://www.starwood.com/whotels/service/index.html lxv Belgum, Deborah, Own Brand of Whiskey, Los Angeles Business Journal, October 14, 2002. lxvi Ibid. lxvii Conversation with Robert Koren, VP of Operations, W Hotels, on Thursday, February 6, 2003. lxviii http://www.starwood.com/whotels/meetings/index.html lxix Conversation with Robert Koren, VP of Operations, W Hotels, on Thursday, February 6, 2003. lxx HSMAI Foundation Focuses Research on Defining Value Drivers For Business, Leisure Hotel Customers, www.hotelresource.com, December 18, 2002. lxxi Ian Schrager Completes Standardization on HIS epitome Property Management System, www.hospitalitynet.com, January 6, 2003. lxxii Summary of Portfolio by Properties and Rooms, as of June 30, 2002, p. 1, www.starwood.com. lxxiii www.starwood.com/corporate/company_info.html, p. 4. lxxiv www.starwood.com, About the Company, p. 1. lxxv Travel Pros Give Starwood Brands Top Honors in Business Travel News U.S. Hotel Chain Survey, Business Wire, February 11, 2002. lxxvi Savvy Travelers Vote 56 Starwood Hotels and Resorts to Cond Nast Travelers 2002 Gold Lists, Business Wire, January 7, 2002. lxxvii Conversation with Robert Koren, VP of Operations, W Hotels, on Thursday, February 6, 2003. lxxviii Brown, Ron, Hospitality Conference Presentation, November 2002, www.starwood.com/corporate/investor_relations.html, slide 35. lxxix HSMAI Foundation Focuses Research on Defining Value Drivers For Business, Leisure Hotel Customers, www.hotelresource.com, December 18, 2002. lxxx Conversation with Robert Koren, VP of Operations, W Hotels, on Thursday, February 6, 2003. lxxxi Ibid. lxxxii Ibid. lxxxiii Savvy Travelers Vote 56 Starwood Hotels and Resorts to Cond Nast Travelers 2002 Gold Lists, Business Wire, January 7, 2002. lxxxiv Falcone, Mark, Hausler, Eric, and Attie, Joshua, Starwood Hotels & Resorts: Coverage Initiated Embedded Growth Opportunities, Deutsche Bank Securities Inc. , August 6, 2002, p. 35. lxxxv Ibid., p. 35-36. lxxxvi Marriott to Reposition Renaissance as Boutique Brand, www.hotelbusiness.com, August 27, 2001 (citing Bill Marriott, as quoted in the Wall Street Journal ).
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Berke, Jonathan, Marriot (sic), Bulgari Launch Boutique Hotel Chain, The Daily Deal, M&A Section, February 13, 2001. lxxxviii OConnor, Stefani C., Battered Boutique Label Needs Lifestyle Change: Panel, www.hotelbusiness.com, April 26, 2002. lxxxix Ibid., with quotations from Brad Wilson, General Manager of the W-Union Square Hotel. xc Conversation with Robert Koren, VP of Operations, W Hotels, on Monday, February 3, 2003. xci Bray, Chains Awake to Designer Trend: Boutique Hotels, Financial Times, FT Report: Business Travel, September 26, 2002, p. 2. xcii Fong, Tony, Boutique Hotels Hit Harder Than Other Segments; Recovery Will Take Longer, The San Diego Union-Tribune, August 21, 2002. xciii Lee, Gary, The End of the Boutique Hotel? The Washington Post, Travel, p. E01, April 21, 2002. xciv Binkley, Christina, Bloom Fades at Boutique Hotels, The Wall Street Journal , cited in The Chicago SunTimes , Travel Section, p. 6, March 17, 2002. xcv Starwood 2001 Annual Report, p. 4. xcvi Berke, Marriot (sic), Bulgari Launch Boutique Hotel Chain, The Daily Deal, M&A Section, February 13, 2001. xcvii Binkley, Bloom Fades at Boutique Hotels, The Wall Street Journal, cited in The Chicago Sun-Times, Travel Section, p. 6, March 17, 2002. xcviii Lee, The End of the Boutique Hotel? The Washington Post, Travel, p. E01, April 21, 2002. xcix Starwood Reports Fourth Quarter and Full Year 2002 Results, Business Wire, January 29, 2003. c Conversation with Drew Patterson, Starwo od revenue management executive, February 12, 2002. ci Lobby, W New Orleans French Quarter cii Guest Room, W Times Square ciii W New Orleans civ W New York The Court cv W San Francisco cvi W New York Union Square cvii W Sydney cviii W Suites Newark, CA cix Hudson Hotel, New York cx The Paramount Hotel, New York cxi The Delano Hotel, Miami Beach cxii The Clift Hotel, San Francsico

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