goldman sachs us lodging primer 2jun06[1]

Industry Primer

" The Goldman Sachs Group, Inc.

June 2, 2006

Coverage view: Attractive

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US Lodging United States

The essentials of lodging investing. This is the place to either start research on this diverse $123-billion industry or to brush up on a specific industry topic. We explain what to look for in a lodging franchise, detail the most pressing questions facing the industry, and discuss operating metrics and profit drivers.

Steven E. Kent, CFA Goldman, Sachs & Co. [email protected] New York: 1-212-902-6752

Julia D. Crowell Goldman, Sachs & Co. [email protected] Chicago: 1-312-362-4775

Jared Miller Goldman, Sachs & Co. [email protected] New York: 1-212-934-0150

Analysts employed by non-US affiliates are not required to take the NASD/NYSE analyst exam.

Global Investment Research

The basics Lodging fundamentals, size and segmentation, key risks, *New* Pricing power analysis, *New* Customer mix and its impact on profitability, *New* Why returns for new hotel builds remain low, *New* Meta-search and its impact on lodging.

The players Competitive landscape, top-ten brand franchise characteristics, questions for management.

The numbers Valuation and stock selection metrics, growth and earnings drivers.

What’s inside . . .

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Lodging United States

Goldman Sachs Global Investment Research - June 2, 2006

Table of contents

1 What’s new in this issue

2 From the analyst’s desk

7 The basics

8 Industry profile

9 Size, segmentation, and history of the lodging industry

14 How hoteliers make money and generate returns

18 Lodging fundamentals

23 Ways to grow lodging companies

25 * New* Pricing power comparisons suggest hotels still have more to go; upside more significant for high-end hotels

27 *New* A closer look at customer mix and its impact on hotel profitability

30 * New* Returns on new hotel development remain low

32 * New* Big Three lodging companies continue to evolve

36 A closer look at International expansion opportunities

39 A closer look at timeshare operations

45 Hotels have neutralized Internet threat

55 *New* Meta-search: the next frontier for lodging distribution over the Internet

56 Key industry risks

57 Lodging consumer characteristics

59 The players

61 Analysis of industry competitors

65 A closer look at lodging REITs

69 Top ten brand franchise characteristics

71 What to ask company management

73 The numbers

74 Valuation and stock selection metrics

79 Key earnings drivers

80 Economic and demand indicators

81 Analyzing lodging performance

87 More resources

88 An inside look at frequent guest programs

92 Appendix I: industry terminology

94 Appendix II: additional sources of information

96 Regional research team

99 Disclosures

The prices in this report are based on the market close of May 31, 2006.

United States Lodging

Goldman Sachs Global Investment Research - June 2, 2006 1

What's new in this issue

This revised lodging primer contains several new items, including an analysis and discussion of the following topics:

• From the analyst’s desk. In this analyst’s desk section of the revised lodging primer, we continue to review our case for further investment in the lodging sector, giving investors four more reasons why they should feel comfortable in this continued lodging recovery.

• Hotel pricing power analysis. We have taken a look back at peak lodging pricing and remain comfortable in our companies’ abilities to continue to push rates well into 2007 and potentially beyond. In this section we take a closer look at the recovery over the past few years and potential upside going forward.

• Customer mix and its impact on pricing power at the hotel level. Modest shifts in customer mixes can drastically alter a hotel’s ability to drive last-minute rates in periods of high demand. In this section we analyze customer mix at the hotel level and its impact on the bottom line.

• Returns on new hotel development remain low. In this section we lay out why unlevered returns for new hotel builds remain so low. We think this will continue to keep near-term high-end supply growth at bay.

• International expansion and recent acquisition/disposition activity has drastically altered the hotel portfolios for the Big Three lodging companies. We take a closer look at their recent evolutions toward more global fee-based enterprises. In addition, we lay out what these companies may look like in 2010.

• Meta-search engines and their impact on hotels’ bottom lines. We believe that meta-search engines such as Kayak.com and Sidestep.com represent the next frontier for lodging distribution over the Internet. The potential business opportunity for our branded hotel companies is real as these meta search aggregators are shifting more and more consumers toward the hotel companies’ lowest distribution channel at a cost significantly less than third-party online travel agents.


2 Goldman Sachs Global Investment Research - June 2, 2006

From the analyst's desk

Supply low-demand high, buy hotel stocks The investment thesis on the hotel sector is very straightforward. There is little new supply and demand is very strong due to a surging business traveler. This imbalance is creating the opportunity for pricing power, which is leading to outsized earning gains. Earnings should continue to surpass expectations and drive the stocks higher, in our opinion. To us it seems this is simple, but we have found that some investors are still staying on the sidelines out of fear that they are missing something and that it cannot be that transparent. Some investors are fearful that they have missed all of the upside, but in this analyst’s desk section we try to show how we believe there is much more to go in this story.

The lodging stocks are currently valued toward the high end of their historical EV/EBITDA valuation ranges and investors appear to be concerned by this valuation. We would point out that private equity multiples are much higher than public valuations currently. In fact, over the past two years, Blackstone has acquired Meristar Hospitality, La Quinta, Wyndham, and Extended Stay America at multiples in excess of 13X forward EBITDA and Fairmont was recently purchased for over 16X forward EBITDA. These multiples are much higher than where our lodging companies are currently trading, which on average is in the 10X-13X range on 2006E EBITDA and 9X-11X range on 2007E EBITDA.

In addition, we would point out that earnings estimates are likely to go higher as RevPARs remain strong and operating leverage brings more and more dollars to the bottom line. Consensus estimates for Starwood, Marriott, and Hilton were raised 25% and 16% on average in 2004 and 2005, respectively, suggesting that the earnings forecast in the beginning of each year have significant upside potential. The lodging managements have typically been very conservative in the beginning of the year and we would expect them to continue to raise estimates throughout 2006 if current demand trends hold steady. With the overall lodging sector showing such strong fundamentals, we continue to be very bullish on the group and its outlook for the next two to three years.

In this analyst’s desk section of the revised lodging primer, we continue to review our case for further investment in the lodging sector, giving investors four more reasons why they should feel comfortable in this continued lodging recovery.

We believe we are only in the middle stages of this lodging recovery.

Private equity money has been chasing lodging real estate over the past two years.



Reason number 1: high-end supply growth should be held in check by low returns and high construction costs

We continue to believe that supply growth will remain in check for the lodging segment, with PricewaterhouseCoopers forecasting US supply growth of just 1.1% and 2.0% for 2006 and 2007, respectively. Luxury supply growth is forecast to be up 1.4% and 2.3% and upper upscale is estimated to be up 1.4% and 2.2% in 2006 and 2007, respectively.

Current hotel returns on new builds are low, keeping development in check The main reason that supply should continue to be held in check, in our opinion, is the low returns on new hotel builds currently. According to Marriott International, unlevered returns on its new high-end hotel builds are approximately 7%-8%, with levered returns in the low- to mid-teens range currently. We would need to see the return metrics increase to at least 10%-12% unlevered and 18%-20% levered before we would grow concerned about a more meaningful uptick in high-end hotel supply.

High construction costs and other expenses are offsetting RevPAR improvements The main hindrance to higher returns are higher construction costs and rising expenses, as RevPARs have rebounded nicely, up 7.8% in 2004 and 8.4% in 2005. According to Marriott International, construction costs escalated in 2004, up 10.5% on average, only to be followed by an additional 6.5% increase in 2005 and an estimated 4%-6% increase in 2006. Recent hurricanes and high demand from China and other growing economies are keeping construction and raw material costs on their upward trajectory. In addition, construction services (i.e., labor, construction managers) are being stretched as rebuilding efforts continue throughout the country from recent hurricane activity.

At the same time construction costs have risen overall expenses have also increased, with insurance, healthcare and benefits, and energy showing double-digit annual increases over the past few years in some cases. Combined expenses have grown much more than RevPAR, creating profit performance that is less robust than investors perceive.

The good news about all of this bad news is that it makes construction of new hotels even less compelling and could result in an extended low supply environment for more years to come.

Hotel developers prefer mixed-use projects, which are limiting new room additions The majority of high-end, full-service projects that are being done currently are mixed-use projects, with the majority of the structures allocated to condos, residential apartments, and timeshares. We are not seeing 400- and 500-room hotels being added anymore, but instead just 150- to 200-room hotels accompanied by these residential and timeshare components. We are even continuing to see developers taking hotel rooms out of service to be reconfigured and repositioned as residential units or retail space.

The net result is that if hotels are being built the scope is much less than what we have seen in past cycles. This time around we do not expect to see big-box (500-plus

Hotel supply actually declined in major markets like New York in 2005.

See page 30 for our full analysis on why hotel returns are so low currently.

Rising expenses have hindered more robust margin expansion to date.



rooms) hotels opening in a Top 25 market, causing disruption in the supply demand imbalance.

Reason number 2: significant pricing power potential remains Even though we are in the third year of above 6% annual RevPAR growth, we note that on a nominal basis RevPAR has only grown 6.2% since the last peak achieved in 2000 and on a real basis actually remains 6.3% below its peak level. We think this leaves the potential for significant pricing power, as RevPAR and rates have only grown at a CAGR of 1.2% and 1.3%, respectively, since 2000, well below the rate of inflation of 2.5%.

Rates should go higher With an extremely price-insensitive, location-sensitive transient business traveler now comprising the bulk of room night stays, we remain comfortable in our hotels’ abilities to continue to push rates further.

The fact is that business traveler profiles and actions have not changed all that much. They want to stay in a hotel that is close to their first meeting or where the meeting/conference is being held. That is why location remains the critical factor in how guests choose hotels and also why they will pay so much for these prime locations. It will take a significant price increase to get people to stay in a cities’ suburbs rather than paying to be downtown. With limited supply growth and a price-insensitive consumer, hotels are one of the few sectors to have real pricing power currently, in our opinion

Reason number 3: continued changes in customer mix are driving average daily rates

As discussed above, the transient business traveler continues to drive rates upward in the hotel sector as we are in the midst of a continued shift in customer mix from lower-priced contract and group bookings to higher-rated group and premium transient bookings. This is bringing hard dollars down to the bottom lines and should continue as hotel demand remains strong.

Mix shift between three customer types driving average daily rates Under a normalized operating environment, the customer mix at a typical full-service hotel is roughly 55% transient, 42% group, and 3% contract. During the post-September 11 period, we saw full-service customer mix change dramatically across the hotel industry. Full-service Marriotts, Sheratons, Westins, and Hiltons were forced to fill excess inventory with much-lower-rated group business (sports teams, associations, weddings, etc.) and even-lower-rated contract business (i.e., airline crews). In fact, contract business, which typically garners just 3% share, grew to roughly 8% share across the Marriott full-service brand.

On average we estimate that transient rates are in the $400-$500 range, group rates are in the high-$200 to $300 range, and contract rates are in the $70-$150 range across full-service hotels in the major markets. A mix change from a contract to a transient

We believe the lodging sector is one of the few sectors with real pricing power currently.

The move in RevPAR is a function of mix change as much as pricing power.

See page 27 for our full analysis on this customer mix change.



booking would result in a significant pricing differential that would have an immediate and meaningful impact on a hotel’s profitability.

Simply put, if a room that was previously occupied by an airline crew member who was paying just $70 per night on average were to be replaced by a transient business traveler paying over $400 per night, the hotel would see an incremental $330 fall to the bottom line. The cost of maintaining the room is the same no matter who stays, so this incremental rate upside is nearly pure profit for the hotels.

Mix shifts within transient and group segments driving average daily rates We are also seeing a mix shift within the transient and group segments themselves, which is contributing to the rate upside. Hotels continue to limit special corporate rates, which historically have been at a 20%-30% discount to standard corporate rates. In addition we are seeing the quality of group bookings increasing as groups are forced to pay up or move meetings to cheaper market locations. Group meeting planners that have previously expected to call in to get a “group discount” on rooms are finding themselves surprised when offered rates close to corporate and premium rates. Hotels are holding back inventories, which is allowing them to more effectively drive these last-minute rate increases.

Customer mix changes take time to evolve We would point out that many hotels have bookings locked in two to three years in advance. We are still in a period where lower-rated group bookings reserved two to three years ago are filling hotel space. As the hotels continue to mix shift contract and other lower-rated group bookings out, we should continue to benefit from above-average rate increases.

Reason number 4: Big Three hotel companies are moving more and more toward global fee-based enterprises

Marriott, Starwood, and Hilton continue to lessen real estate exposure and focus more and more operations on the high-recurring, less capital-intensive management and franchise fee streams domestically and abroad. This should lead to higher free cash flow generation, improving returns, higher unit growth potential, more stable earnings results over time, and ultimately higher valuations, in our opinion.

Starwood is in the midst of its asset disposition initiative, selling over $5 billion in assets over the past two years and targeting an additional $500 million to $1 billion over the next 12-18 months. Hilton has been churning its hotel portfolio as well selling over $1.2 billion in assets since May of 2005. We continue to expect Hilton to sell non-strategic assets associated with its Hilton International acquisition, lessening its owned/leased dependence, with a greater focus on management and franchise operations going forward.

And Marriott should continue to recycle capital via asset dispositions and loan repayments, which should allow it to continue to promote further unit growth both domestically and abroad.

More price-insensitive business travelers are replacing discounted corporate and group customers.

Hotels are able to shift groups into lower-occupancy cities, raising the average rates in these markets too.

See page 32 for full details on the changes under way at Marriott, Starwood, and Hilton.

The move toward high free cash flow generation, improving returns, and more international growth should lead to higher valuations over time.



8 Industry profile

9 Size, segmentation, and history of the lodging industry

14 How hoteliers make money and generate returns

18 Lodging fundamentals

23 Ways to grow lodging companies

25 * New* Pricing power comparisons suggest hotels still have more to go; upside more significant for high-end hotels

27 *New* A closer look at customer mix and its impact on hotel profitability

30 * New* Returns on new hotel development remain low

32 * New* Big Three lodging companies continue to evolve

36 A closer look at International expansion opportunities

39 A closer look at timeshare operations

45 Hotels have neutralized Internet threat

55 *New* Meta-search: the next frontier for lodging distribution over the Internet

56 Key industry risks

Th

e basics



Industry profile

Lodging is an influential economic force With nearly 4.5 million hotel rooms and an estimated $123 billion in total revenues generated in the US alone, the lodging industry has become an influential economic force. According to the Travel Industry Association, lodging is a critical component of the overall tourism industry, which generates over $600 billion in sales, pays over $100 billion in federal, state, and local taxes, and supports more than 7 million jobs.

Highly segmented lodging product controlled by a handful of lodging participants The lodging industry is highly segmented in regard to product, with a variety of brands targeting a wide array of price points and consumer needs. More than 70% of the hotels in the US are affiliated with a brand, but no one hotel brand accounts for more than 3% of all hotel rooms in the US. The end result is an industry comprising a multitude of brands that are controlled by a handful of lodging operators. The top ten hotel companies, ranked by number of rooms in the United States, account for more than 65 brands and about 2.4 million hotel rooms. These top ten lodging companies account for more than 54% of the total US room supply (see Exhibit 1).

Exhibit 1: Top ten hotel companies ranked by total US hotel rooms based on 2005 year-end figures

Company

Cendant Corporation 444,964 9.9% 9Marriott International 398,417 8.9% 10Hilton Hotel Corp. 355,489 7.9% 7InterContinental Hotels Group 338,694 7.6% 7Choice Hotels International 326,010 7.3% 10Best Western International 186,426 4.2% 1Accor 134,548 3.0% 6Starwood Hotels & Resorts 121,271 2.7% 7Carlson Companies 77,220 1.7% 4Hyatt Hotels Corp. 56,663 1.3% 4

Total Rooms from Top Ten Companies 2,439,702 54% 65Total Rooms in the US 4,479,113 100%

Total Number of Rooms in the US

Total Number of Brands Operating in the US

Percentage of Total US Rooms

Source: American Hotel and Lodging Association; Cendant rooms from Wyndham Form 10-12B in May 2006.

Hotels derive revenues through a variety of means

Hotels aim to “put heads in beds,” that is, fill up the room with paying customers. This produces the majority of hotel revenues (more than 60%), but additional revenues are earned from food and beverage sales, rentals, Internet use, spa amenities, and other income. Depending on the type of hotel (full service or limited service), these additional revenues can contribute significantly to overall hotel revenues (as much as 37% for full service) or account for a small percentage of overall revenues (as little as 6% for limited service).

More than 70% of the hotel rooms in the US are affiliated with a brand.

Lodging in the US generates roughly $123 billion in revenues.



Size, segmentation, and history of the lodging industry

Size of the Industry • In 2005, the US lodging industry took in almost $123 billion in revenues,

according to Smith Travel Research (see Exhibit 2). Over the past 35 years, the sector has shown compound annual revenue growth of approximately 8%.

Exhibit 2: Lodging revenues peaked in 2005 total US lodging industry revenues

-$10,000

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Source: Smith Travel Research.

• The US industry has 4.5 million hotel rooms. The dominant forces in the lodging sector by number of rooms in the US are Cendant, with almost 445,000 franchised/managed rooms, and Marriott, with over 398,000 rooms. Hilton and internationally based InterContinental also have a significant presence, with more than 355,000 and 338,000 rooms, respectively.

• Of the available 4.5 million hotel rooms at the end of 2005, roughly 2.8 million were sold for an annual occupancy rate of 63.1%, according to Smith Travel Research. This is stronger than the 61.3% occupancy rate achieved in 2004 and close to the 63.3% occupancy achieved in 2000.

• According to the Bureau of Economic Analysis, hotels and other lodging places represented 3% of the services sector gross domestic product (GDP), and almost 1% of overall GDP, in 2004.

• In terms of equity exposure, the hotel industry accounts for 0.30% of the S&P 500 index (as of May 19, 2006), and about 3% of the broader consumer discretionary sector.

Although lodging plays a major role in the US $600 billion tourism industry, lodging stocks account for only 0.30% of the S&P 500.



Exhibit 3: Total lodging-related revenues for hotels under our coverage, 2005 $ millions, includes timeshare revenues, but excludes cost reimbursement revenues

Company RevenueStarwood Hotels & Resorts 4,907Host Hotels and Resorts 3,881Marriott International 3,458Cendant Corp. 3,262Hilton Hotels Corp. 3,218Strategic Hotels and Resorts 493Orient Express Hotels Ltd. 448Four Seasons Hotels & Resorts 248Interstate Hotels and Resorts 222

Source: Company reports, Goldman Sachs Research.

Individual hotels are segmented into brands

Lodging sector is segmented into brands The lodging industry is a highly segmented sector as a result of the slow evolution to a multitude of brands. Over the past three decades hotel companies have developed a variety of brands, which convey to the customer not only consistency and quality of the property for the best brands, but also amenity levels, price ranges, accommodation types, and service levels. Consumers have been educated to the relative merits of these variables and know the difference between a full-service Marriott and a limited-service Hampton Inn based solely on their names.

The end result of the evolution of these many brands is a highly segmented industry with a multitude of products catering to different types of travelers (business versus leisure), different price points (high end versus economy), and different consumer needs (short one-night stays versus three- to four-week stays).

Hotels are segmented primarily into two types Hotels are typically divided into two types: either full-service hotels or limited-service hotels. Full-service hotels are generally mid-price to upscale hotels featuring restaurants, meeting and convention space, and include more labor-intensive services such as room and concierge service. In contrast, limited-service hotels typically do not include food and beverage service and have limited additional amenities.

Hotel operators are segmented into owner/operators, managers, and franchisers Hotel companies can earn revenues from individual hotels in three ways. They can either own, manage, or franchise hotels. Some hotel companies have portfolios consisting of a mixture of the three with hotels that they own and operate, hotels that they manage for third-party hotel owners, and hotels that they franchise.

Even though CD and MAR have more rooms in the US, total revenues are higher for HOT and HST given their higher owned asset exposure. The majority of CD and MAR hotels are either managed or franchised. As a result they only receive a percentage of overall revenues at the hotel level.

As a result of this segmentation, no individual lodging brand accounts for more than 3% of hotel rooms.



Hotel ownership—higher capital risk with greater reward

Hotel ownership is highly capital-intensive, requiring significant up-front investment. Hotel owners bear the direct costs and typically assume losses for the first 12-24 months of operation until the property ramps up to profitability. Full hotel ownership companies are heavily tied to the operating leverage of the hotel business. In good times, hotel owners reap the benefits as revenues increase against a highly fixed expense structure. The opposite is true in slowing times, however, as hotel owners feel the full brunt of slowing revenues on the same fixed expense structure. On the positive side, ownership allows for greater control of the property and allows for the benefits of asset appreciation.

Hotel management—less capital intensive, more brand distribution Companies that specialize in management contracts derive fees for managing the day-to-day operations for third-party hotel owners. These tasks include every aspect of running the hotel from the sales and marketing programs to the hotel reservations and training of employees.

Management companies derive fees for their services in three ways: (1) base fees calculated as a percentage of overall gross revenues at the hotel (typically 3%-5% of revenues); (2) additional fees for services rendered for pre-opening development, purchasing, marketing, reservations, and advertising for the hotel owner; and (3) incentive fees, which serve as an additional bonus for outperformance at the hotel profit level. Incentive fees are typically based on a percentage of adjusted gross operating profits and are usually only paid if a certain threshold level of profits is achieved. This threshold level is typically known as the owner’s priority. On average, incentives can be 10%-30% of a hotel’s profits after an owner’s priority.

Hotel management contracts are less capital-intensive than outright hotel ownership, but hotel management companies have been known to contribute through mezzanine loans and sliver equity to acquire new management contracts. This adds to their risk profile.

Hotel franchises—more brand distribution, less control of operations The third way to make money on hotels is through franchising. Hotel companies that franchise do not own or manage the hotels but essentially license hotel owners the right to their brand name and the perks that come along with it. The franchisee benefits from being affiliated with a brand, as it is included in national marketing and advertising programs, central reservation systems, ongoing training programs for employees, and sales and technology support. In return for these services, the franchiser receives the following fees: (1) one-time application fee; (2) recurring royalty fees, which are typically 4%-6% of room revenues and 2%-3% of food and beverage revenues for full-service hotels; and (3) fees for use of central reservation system. The franchisee is also expected to contribute toward the national marketing and advertising programs.

Cendant is the predominant hotel franchiser, with almost 445,000 franchise hotel rooms in the US. Each additional franchise contract builds Cendant’s global brand presence and brand distribution at minimal incremental cost. The drawback is that Cendant does not have control of hotel operations and upkeep. Brand and service consistency across a

The three forms of hotel ownership are partnerships, corporations, and REITS (real estate investment trusts).

Hotel managers typically contribute their brands to the properties and manage everything from reservations to sales and marketing functions.

Hilton’s Hampton Inn brand is one of the fastest-growing lodging franchises in the US today.



franchised system can be problematic as the franchiser has little control over maintenance expenditures and management of the individual hotels.

Exhibit 4 details the major differences between the three structures. Exhibit 5 breaks down the major lodging operators and their brands.

Exhibit 4: Comparison between hotel ownership, management, and franchise contracts

Hotel revenues 100% Base fee- 3% to 5% Royalty fee- 4% to 6%Hotel profit 100% Variable - 5%-30% Zero

Incentive fees dependent upon contract: (1) % of profit above set threshold (2) % of total operating profit

Capital contribution High Variable Minimal

Benefits to hotel corporation

Drawbacks to hotel corporation

* assumes hotel is owned and operated by same hotel company

Greater downside to operations in a slowing economy given the high operating leverage of the business. Ownership companies feel the full brunt as top line revenues slow against a high fixed expense structure.

Tied somewhat to the operating leverage of the business through incentive fees. Less control over maintenance and upkeep at the property level.

No control over property management or upkeep. Brand consistency can be difficult to maintain across a franchise system.

Allows for aggressive unit growth with minimal capital risk. Less susceptible to operating leverage as base fees are taken as a percentage of overall hotel revenues. Total control over day-to-day operations at the property level.

Greater reward during a growing economy given the high operating leverage of the business. 100% control of overall operations.

Vehicle for brand distribution without capital risk. No ties to the operating leverage of the hotel business as royalty fees are taken as a percentage of overall hotel revenues.

Franchise companies contribute modestly to national and international advertising campaigns to promote their brands.

Ownership companies are responsible for 100% of the development costs. Owners can have partners and can receive mezzanine financing, sliver equity, and loans from additional sources.

Management companies have been known to aid hotel owners through mezzanine financing, sliver equity, and loans. On average management companies will take a maximum 20% interest in hotels.

Ownership * Management Franchise

Source: Goldman Sachs Research.

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Exhibit 5: Brand affiliations broken down by company

Company Accor Best Western International Cendant Corporation Choice Hotels Four Seasons Hotels Hilton Hotels Corp.Owner/manager/franchiser Franchiser Franchiser/Manager Franchiser Owner/Manager Owner/Manager/Franchiser

Brands Motel 6 Best Western Wyndham Comfort Inn Four Seasons Conrad HotelsNovotel Days Inn Comfort Suites Regent DoubletreeRed Roof Inns Ramada Quality Inn Embassy SuitesSofitel Super 8 EconoLodge Hampton Studio 6 Howard Johnson Clarion Hotels Hilton HotelsIbis Travelodge Sleep Inns Hilton Garden InnEtap Knights Inn Rodeway Inns Homewood Suites by HiltonFormule 1 Wingate Inns MainStay Suites Hilton Grand Vacations ClubDorint Amerihost Cambria Suites The Waldorf-Astoria CollectionMercure Suburban Extended Stay Hotel ScandicSuitehotelAccor VacancesAccor Thalassa

Company Host Hotels and Resorts InterContinental Hotels InterState Hotels & Resorts Marriott International Orient Express Hotels Starwood Hotels & ResortsOwner-REIT Owner/manager/franchiser Manager Owner/Manager/Franchiser Owner Owner/Manager/Franchiser

Brands Marriott Inter-Continental Marriott Marriott Hotels & Resorts No affiliated brand WestinRitz-Carlton Crowne Plaza Hilton Garden Inn JW Marriott Hotels & Resorts SheratonHyatt Indigo Sheraton The Ritz Carlton Four PointsHilton Holiday Inn Holiday Inn Renaissance Hotels St. Regis/Luxury CollectionFour Seasons Holiday Inn Express Hampton Inn Bulgari Hotels & Resorts W HotelsFairmont Staybridge Suites Doubletree Courtyard W AloftWestin Candlewood Suites Courtyard Residence Inn Le MeridienSheraton Radisson Fairfield InnSt. Regis/Luxury Collection Residence Inn TownePlace SuitesW Westin Spring Hill Suites

Crowne Plaza Corporate ApartmentsEmbassy Suites ExecuStayRenaissance Marriott Executive Apts.Wyndham HotelsHomewood Suites Fairfield InnHilton Garden InnDoralHoliday Inn ExpressSheraton Four PointsComfort InnHoliday Inn SelectAmerisuitesHawthorne SuitesCounty Inn and SuitesBest WesternEconomy Inn and SuitesEcono LodgeRamada InnLa QuintaComfort SuitesStaybridge SuitesQuality Inn

Company Strategic Hotels and ResortsOwner-REIT

Brands FairmontFour SeasonsHiltonHyatt RegencyIntercontientalLoewsMarriottRitz-Carlton

Source: Company data.



How hoteliers make money and generate returns

Below we lay out the three ways that hotel companies can make money (hotel ownership, hotel management, and hotel franchising) and the returns each method generates. In addition, we give examples of how each of these methods is accounted for on the income statement and the balance sheet, and discuss the returns generated through each method. From these examples, it is clear that revenues earned on managed and franchised operations provide infinite returns whereas revenues derived from owned hotels have capped returns and put more capital at risk.

In each case illustrated below, we have assumed that Marriott either owns a hotel outright, manages the hotel for a fee, or franchises the hotel. We point out that all hotel companies in our coverage universe with the exception of hotel REITS can participate in hotel ownership, hotel management, and hotel franchising. We are merely using Marriott as our example for simplicity’s sake.

Hotel ownership: returns are minimal For hotels that are owned outright, revenues mainly consist of sales of hotel rooms, food and beverage, and other revenues such as parking fees, Internet usage, and telephone charges. On the income statement, total revenues generated at the hotel level are recorded as owned hotel revenues with associated operating costs. On the balance sheet, the company records the hotels’ buildings, land, and other assets under property and equipment.

Exhibit 6 illustrates the revenue stream from a typical Marriott-owned hotel and the way in which events are accounted for on the company’s financial statements. In this example, the owned hotel generates $24 million in revenues ($15 million of room sales and $9 million of food and beverage sales) and incurs $16 million of operating costs, both of which are recorded on Marriott’s income statement.

On the balance sheet, Marriott records the cost of the hotel’s land, buildings, and other assets ($55 million). The hotel’s operating profits are $5 million, for a pretax margin of 21%. If we take pretax income and divide it by the cost of the hotel, the return on invested capital (ROIC) is 9%, which is low compared with the nearly infinite returns earned on managed and franchised operations. As a hotel owner, Marriott’s risk exposure is higher during economic downturns for these owned hotels as sales tend to decline more than costs.

However, we point out that even though these returns and margins may be lower, the actual dollar contribution for an individual hotel is higher when Marriott owns it outright, versus a hotel where Marriott is receiving just the franchise or management fees.



Exhibit 6: Owned hotels—impact on hotel owner’s income statement & balance sheet revenue and expense structure for an owned hotel; $ millions

F&B/Other: $9Marriott Financial Statements

Income Statement:Room Sales $ 15F&B/Other Sales 9Total Revs 24Oper. Exps. 16 Oper. Profit $ 8 Depreciation 3EBIT $ 5

Balance Sheet:Cost of Hotel�sPP&E $ 55

Room: $15

Marriott

Operating Costs:$16

ROIC: 9%

F&B/Other: $9Marriott Financial Statements

Income Statement:Room Sales $ 15F&B/Other Sales 9Total Revs 24Oper. Exps. 16 Oper. Profit $ 8 Depreciation 3EBIT $ 5

Balance Sheet:Cost of Hotel�sPP&E $ 55

Room: $15Room: $15

Marriott

Operating Costs:$16

Operating Costs:$16

Operating Costs:$16

ROIC: 9%

Source: Company data, Goldman Sachs Research estimates.

Managing hotels: provides almost infinite return on capital The second way that hotels can make money is through hotel management. As a hotel manager, a company such as Marriott, Hilton, Starwood, or Four Seasons is responsible for the day-to-day running of the hotel and overseeing administrative functions, such as hiring and supervising employees. The hotel manager also provides managed hotels with services such as a centralized reservation system, national advertising, and accounting assistance.

In contrast to an owned hotel, Marriott as the hotel manager does not own the hotel’s land or buildings; therefore, it does not have property and equipment associated with the managed hotel on its balance sheet. Marriott’s income statement captures management fee revenues, which comprise base and incentive fees. These fees are paid by the hotel owner (typically a real estate fund, private equity fund, or REIT) for the services that Marriott provides on a day-to-day basis. Base fees are calculated as about 3%-5% of a hotel’s revenues, and incentives fees vary considerably but average 10%-30% of a hotel’s profits after an owner’s priority. An owner’s priority is the amount of operating profits that must go to the owner before any profits are shared with others, such as a manager like Marriott—in other words, it is the owner’s minimum return.

Exhibit 7 illustrates how a company like Marriott would account for its management contracts and the typical returns it would achieve. In this example, a managed hotel generates $24 million in revenues and $7 million in operating profits. After deducting the owner’s priority of $6 million, the hotel has $1 million in cash available for incentive fees. The hotel owner pays Marriott a base fee of $720,000 (3% of the managed hotel’s revenues) and an incentive fee of $300,000 (30% of cash available for the incentive fee). Marriott records these fees as revenues on its income statement and deducts associated overhead costs (e.g., accounting and other administrative costs). Given that Marriott does not have to spend money to build the hotels, its ROIC is nearly infinite.

Base fees are typically 3%-5% of revenues. Incentive fees are typically 10%-30% of operating profits.

In this example, we are assuming no equity interests or loans to the individual hotels by the hotel manager.



Exhibit 7: Managed hotels—impact on hotel manager’s income statement & balance sheet revenue and expense structure for a managed hotel; $ millions

Room: $15 F&B/Other: $9

Managed Hotel

Operating Costs:$17

Marriott Financial Statements

Income Statement:Mgmt. Revenues

Incentive Fees $ 0.30Base Fees 0.72

Total Mgmt. Revs. 1.02 Overhead Costs .30 Oper. Profit $ 0.72

Balance Sheet:Hotel PP&E $ 0

Managed Hotel Inc. Stmt.Revenues: $ 24Oper. Costs: 17Oper. Profit $ 7Owner�s Priority 6Cash Avail. For Fees $ 1

Incentive Fee: 30% X Cash Available for Incentive Fee = $0.30

Base Fee: 3% X Managed Hotel Revenues = $0.72

ROIC: Infinite


Managed Hotel

Operating Costs:$17

Operating Costs:$17

Operating Costs:$17


Income Statement:Mgmt. Revenues

Incentive Fees $ 0.30Base Fees 0.72

Total Mgmt. Revs. 1.02 Overhead Costs .30 Oper. Profit $ 0.72


Managed Hotel Inc. Stmt.Revenues: $ 24Oper. Costs: 17Oper. Profit $ 7Owner�s Priority 6Cash Avail. For Fees $ 1

Incentive Fee: 30% X Cash Available for Incentive Fee = $0.30

Base Fee: 3% X Managed Hotel Revenues = $0.72

ROIC: Infinite


In terms of risk exposure, the incentive fees tend to be more affected during economic downturns because they are calculated as a percentage of a managed hotel’s profits. Nonetheless, management fees are highly profitable because the hotel owners bear all the direct operating costs. We also point out that the hotel manager does not profit from providing services, such as national advertising and reservations. The company “pools” all the fees received from its managed properties for such services and uses them to acquire such services on behalf of all its managed properties.



Franchised hotels: great source of profit, limited capital exposure Hotel companies such as Marriott can also franchise their brand names to hotel owners in exchange for a franchise fee. A Marriott that is franchising its services does not own or mange any of the franchised hotel properties. Instead, hotel owners are responsible for running the hotel, and they are entitled to use one of Marriott’s brand names in exchange for a franchise fee. Accordingly, Marriott as the franchiser would record no assets on its balance sheet.

Franchise fees are calculated as an initial application fee plus an ongoing royalty fee, which typically ranges from 4% to 6% of room revenues, plus 3% of food and beverage revenues. In addition, franchisees must contribute to Marriott’s advertising and marketing programs and pay fees to use its reservation system. Marriott collects advertising and other fees on behalf of all its franchised hotels and uses them to pay for these services. The company does not profit from these activities.

Exhibit 8 depicts how Marriott, acting as a franchiser, would account for its franchised revenues and expenses on its financial statements. In this example, the franchised hotel owner/operator pays Marriott 6% of its room sales ($900,000) and 3% of food and beverage revenues ($270,000) in the form of franchise fees. Marriott records these fees as revenues on its income statement and deducts overhead costs associated with franchised operations. As mentioned above, Marriott does not own the franchised hotel, so it does not record anything on its balance sheet. Given that Marriott does not have an investment in its franchised hotel, returns on capital are nearly infinite.

Exhibit 8: Franchised hotels—impact on franchiser’s income statement and balance sheet revenue and expense structure for Marriott’s franchised hotels; $ millions


Franchised Hotel

Operating Costs:$17


Income Statement:Franchise Fees $ 1.17Overhead Costs 0.40 Oper. Profit $ 0.77


Franchised Hotel Inc. Stmt.Revenues: $ 24Oper. Costs: 17Oper. Profit $ 7

Franchise Fee: $1.17 (a) 6% X Room Rev. = $0.90(b) 3% X F&B/O Rev. = $0.27

ROIC: Infinite


Franchised Hotel

Operating Costs:$17

Operating Costs:$17

Operating Costs:$17


Income Statement:Franchise Fees $ 1.17Overhead Costs 0.40 Oper. Profit $ 0.77


Franchised Hotel Inc. Stmt.Revenues: $ 24Oper. Costs: 17Oper. Profit $ 7

Franchise Fee: $1.17 (a) 6% X Room Rev. = $0.90(b) 3% X F&B/O Rev. = $0.27

ROIC: Infinite


Cendant is the biggest franchiser of hotels, with over 6,300 franchised hotels and more than 525,000 franchised rooms currently in its worldwide system.

Franchise fees are highly profitable because the hotelier (MAR, HOT, HLT) does not incur any of a hotel’s operating costs.



Lodging fundamentals

The lodging industry is a highly consolidated and regulated industry, creating high barriers to entry for new lodging companies. This creates significant opportunities for the existing participants who have significant expansion potential abroad. The building of brands takes time, and new participants are rare. We believe international expansion will be a key driver of growth over the next several years as our hotel companies continue to consolidate the sector, making acquisitions and growing organically.

Key economic characteristics • Lodging is part of the hospitality sector, making hotel revenues highly cyclical and

dependent on domestic and international consumer travel. Revenues for hotel companies (conference/convention/ group business) are greatly affected by corporate travel budgets.

• The industry is concentrated into a handful of major lodging competitors, but the sector is highly segmented with respect to products as no one hotel brand comprises more than 3% of the US hotel rooms. These brands are diversified geographically and by price point, with the exception of a few niche competitors.

• Overall, lodging operators are at the mature end of the business lifecycle in the US, although we admit that with the recent decline in the sector following 2001, they have yet to recover to peak margin and operating performance. We do think that once these companies recover internal growth may be difficult to come by. Competition remains fierce given the segmented nature of the business and concentrated focus of the individual brands. Untapped markets in fragmented Europe (less than 25% of hotels carry a brand) and Asia, conversion opportunities from existing hotels, along with brand extension opportunities (timeshare, residential communities) will spark future lodging growth, in our opinion.

• High barriers to entry, particularly in city and resort locations, characterize the lodging industry as regulatory hurdles for new builds are substantial, upfront construction costs and time are significant, and growth is capital intensive. Barriers for management companies come in the form of brand recognition and consumer preference, which all take time to build. State-of-the-art reservation systems, national and international advertising programs and frequent guest programs also serve as barriers to entry for new participants.

Industry economics In our view, three key factors influence the lodging sector: (1) supply and demand dynamics, (2) the state of the overall economy, and (3) the availability of capital.

Lodging revenues are cyclical.



Low supply growth is key for lodging outperformance Favorable industry fundamentals—low supply growth accompanied by solid demand for hotel accommodation—tend to be positive signals for industry revenue growth rates. Room supply is a function of the rate of change in inflation-adjusted room rate, availability of capital, and cost of construction, which are dependent on factors such as the level of interest rates, regulatory requirements (i.e., zoning approval), and investors’ willingness to lend.

We believe that supply growth is one of the most important factors for hotel companies in the long term. On the supply side, we monitor construction starts and new room additions. When supply outpaces demand, downward pressure is placed on room rates, thereby pressuring lodging revenues. Investors can deal with slowing demand, because they know that eventually the economy will recover. Continued supply growth, however, is difficult to overlook as it creates a permanent obstacle to overcome in each market.

As shown in Exhibit 9, supply surged in the mid- to late 1980s owing to looser lending practices by savings and loans (S&Ls) and tax advantages for building. Supply reaccelerated in the early 1990s as a result of the improving capital markets and higher demand. Supply growth peaked in 1998, but has remained below the 2.5% average annual growth rate for the past 5 years. The downturn in 2001 helped keep supply growth low through 2003 and it has remained low despite the lodging rally over the past two years, with RevPAR up 7.8% in 2004 and 8.4% in 2005. High construction costs, low returns, and the shift toward more mixed-use hotel projects continues to limit the amount of high-end supply entering the major markets currently.

Exhibit 9: Total US lodging industry supply growth has averaged under 2.5% from 1968

0%

2%

4%

6%

8%

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

% Change supply Industry average

Source: PricewaterhouseCoopers (1967-1986), Smith Travel Research (1987-2005).

Supply growth has decelerated below the long-term average of 2.5% over the past five years.

PricewaterhouseCoopers currently estimates that supply growth will remain low at 1.1% in 2006 and 2% in 2007.

PricewaterhouseCoopers has provided data prior to 1987 and Smith Travel Research has provided data after 1987.



Hotel companies face the prisoner’s dilemma (see Exhibit 10) when determining unit growth, additional franchise and management contracts, amenity levels, and other variables. If one hotel develops more aggressively than its competition, it gains market share and increases profits at the expense of the other hotels in the market. When all the hotels decide that accelerating unit growth and adding more grandiose amenities will maximize profits, the resulting overcapacity minimizes revenue gains and reduces profits for all. The same dilemma occurs when hotels use reduced fees to attract property owners and use amenities and services to attract the consumer.

The prisoner’s dilemma is further complicated by the conflicting strategies of management/franchise companies and real estate owners. Management and franchise companies benefit from unit growth because they gain additional fees and are not as affected by the deceleration in RevPAR growth rates from increased supply. They do not have as much operating leverage as the owners of properties do. In contrast, real estate owners would like to see limited development, so that they can continue to raise prices without facing supply-induced competition. Thus, management companies often accelerate their unit growth in a downturn to maintain earnings growth, and hotel owners suffer the consequences.

Exhibit 10: Prisoner’s dilemma

D

ON

'T B

UIL

D

B

UIL

D

Com

pan

y B

WIN/LOSE LOSE/LOSE

Company ADON'T BUILD BUILD

WIN/WIN LOSE/WIN


Availability of capital is important criterion for growth The final critical factor is the availability of capital for development and capital maintenance opportunities. Hotels can increase revenues by adding to their unit count or making acquisitions. Both of these options depend on availability of capital. Equally reliant are projects to refurbish properties or change hotel brands. The lender’s receptivity to providing capital for these sizable investments is influenced by interest rates and the operator’s existing debt levels.

Consolidation trends--have heated up in 2005 and 2006 In the late 1990s, we saw extensive consolidation in the lodging industry as the larger competitors acquired more brands and disposed of their gaming assets. The larger more mature ownership companies (i.e., Hilton) acquired management and franchise vehicles

In the end, few benefit from the development game because oversupply depresses returns for all.

If everyone builds, everyone loses.



(i.e., Promus) to diversify revenues and broaden their business mix. Other companies such as Marriott, which already had a diverse portfolio of products, selectively acquired additional brands (i.e., Renaissance, Ritz Carlton) to fill market niches and price points in their hotel portfolios.

The larger more mature hotel companies had a distinct advantage in this consolidation trend using their larger balance sheets and less expensive sources of capital to acquire competitors and niche operators. These mergers have helped the larger corporations to build out their systems, taking advantage of economies of scale to increase profits. Cross-selling opportunities have also been a dominant driver of increased market share for the larger operators that are now operating with a variety of brands in a variety of locations and price points.

We have recently seen the second leg in this public consolidation trend following the lodging downturn at the turn of the century. Hilton Corporation, based in the US, recently completed its purchase of Hilton International, and Starwood acquired the Le Meridien brand. In addition, we have seen significant activity from private equity funds that have taken out lodging companies such as Extended Stay America, La Quinta, MeriStar Hospitality, Wyndham International, and Fairmont Hotels & Resorts.

Exhibit 11 shows some of the past lodging deals.

Private equity funds such as Blackstone have helped to consolidate ownership in the lodging sector.



Exhibit 11: Recent lodging deals does not include individual hotel sales

Date Acquiror Target

Total consideration ($mn)

Forward EV/EBITDA

Forward EV/EBITDA multiple after synergies

Forward P/E

May-06 JER Jameson Inns 371 9.8xMay-06 Braveheart Holdings Boykin Lodging 416 NAFeb-06 Blackstone Group Meristar Hospitality 2600 13.0xFeb-06 RLJ Development White Lodging 1700Jan-06 Colony Capital / Kingdom Hotels Fairmont Hotels and Resorts6 3900 16.4xDec-05 Hilton Hotels Corp Hilton Group PLC 5710 11.3xNov-05 Host Marriott Starwood 4096 11.4xNov-05 Blackstone Group La Quinta Corp. 3400 14.4x

Jul-05 Colony Capital Raffles Hotels & Resorts 1720 12.3x 23.0xJun-05 Blackstone Group Wyndham International 3240 14.3xFeb-05 JQH Acquisition LLC John Q. Hammons 1294 10.8x - -Dec-04 Goldman Sachs 25 hotels from Wyndham International 366 10.0xDec-04 Hyatt Corp. AmeriSuites 650 - - -Oct-04 Blackstone Group Boca Resorts, Inc. 1250 12.9x - 37.9xAug-04 Blackstone Group Prime Hospitality 790 11.3x - 9.6xJul-04 La Quinta Baymont 395 10.5x - -Mar-04 Blackstone Group ESA 3100 13.5x - 12.2xFeb-04 CNL Hospitality KSL Recreation 2200 11.5x - -

May-03 CNL Hospitality RFS Hotel Investors 688 10.4x - 16.4x (1)

Sep-02 Westbrook Hotel Partners 13 hotels from Wyndham International 447 8.5x 8.5x -

Aug-02 Accor Dorint 50 6.0x - -

May-02 MeriStar Hotels & Resorts Interstate Hotels Corp 260 7.6x 7.6x -Feb-02 NH Hoteles Astron 152 9.0x - -May-01 Nomura Le Meridien 2640 9.5x - -Apr-01 Hilton Group Scandic 962 10.0x 8.0x -Apr-01 Raffles Holdings Swissotel 241 10.4x - -Apr-01 Six Continents Posthouse 1156 7.9x - -Apr-01 MacDo -ld/Bk of Scotland Heritage Hotels 335 5.9x - -Jul-00 Sol Melia Tryp Hoteles 356 9.2x 7.8x -Apr-00 NH Hoteles Krasnopolsky 738 9.6x - 18.3xApr-00 Scandic Hotels Provobis 70 10.2xFeb-00 Six Continents (formerly Bass Plc) Bristol Hotels & Resorts 156.1 10.1x 10.1x 19.0xNov-99 Whitbread Swallow 1122 12.2x 10.0x 15.9xSep-99 Millennium & Copthorne Regal Hotels 640 8.7x 7.5x -Sep-99 Hilton Hotels Corp Promus 4270 9.4x 8.8x 16.7xJul-99 Accor SA Red Roof Inns 1175 7.8x 7.8x 14.0xMay-99 Accor/Blackstone/Colony CGIS (Vivendi) 494 13.5x - -Apr-99 Jurys Hotel Doyle Hotel Group 335 7.7x - -Apr-99 Management & Westbrook Funds Sunstone Hotel Investors 886 9.4x 9.4x -Feb-99 Hilton Group Stakis 2194 11.5x 10.1x 17.8xJan-99 Marriott International ExecuStay 134 - - -Jun-98 Krasnopolsky Golden Tulip 266 10.6x - -Apr-98 Host Marriott 13 Luxury Hotels from the Blackstone Group 1766 9.7x 9.7x -Apr-98 Blackstone & Colony Savoy 908 18.5x - 31.6xMar-98 Felcor Lodging Trust Bristol Hotel Company 1718 8.3x 8.3x 21.6xMar-98 CapStar American General Hospitality 1085 8.7x 8.0x 14.5xFeb-98 Six Continents Inter-Continental 2889 14.7x 12.2x -Jan-98 Meditrust La Quinta Inns 3061 10.4x 10.4x 20.8xaverage 1125 10.2x 9.0x 19.2x(1) Based on FFO/ share

Source: Company data, Goldman Sachs estimates.

Future acquisition opportunities likely niche focused We acknowledge that acquisition opportunities do remain in the lodging industry, as several niche hotel competitors have recently proven the strengths of their business models. We would not be surprised to see further acquisitions by private equity funds or public acquisitions by our companies as they continue to build their footprints abroad.



Ways to grow lodging companies

We see five ways for lodging companies to grow in a relatively mature lodging market:

• Unit growth through new builds or conversions (converting from one brand to another).

• Improving profits through operating efficiencies.

• Accelerating top-line growth by stealing existing market share from competitors.

• Brand extension opportunities such as timeshare and residential communities.

• Growth by acquisition.

Unit growth through new builds and conversions We believe that new builds and conversion opportunities are the best vehicles for growth in the lodging industry. Furthermore, international expansion will likely play a major role over the next decade given the highly fragmented nature of the lodging business outside the US. Europe is the largest lodging market, yet it is highly fragmented with regard to its product, with less than 25% of its hotel rooms affiliated with a brand.

Realizing the advantages of international expansion (e.g., increased brand awareness, brand distribution), US-based Marriott and Starwood have established solid footholds. Hilton just jump-started its presence with its recent acquisition of Hilton International, which added 400 international properties to its total portfolio. We expect international development to begin to account for a larger and larger portion of overall hotel development for the major US-based lodging operators going forward.

Improve operating efficiencies Given the rapid advancements in technology, improving operating efficiencies at the hotel and corporate level are ongoing. Profitability has already been enhanced by more automated services such as customer checkout, billing, and online reservations. The Internet has alleviated a lot of the stress on hotel operators as it has provided an additional means for customers to book reservations and to obtain information.

Increase sales through taking market share Given the high barriers to entry in some of the major lodging markets, increased revenues at the hotel level (absent new unit growth in the market) can generally only be derived from taking market share. We believe that solid brands (backed by excellent service and high product quality) and a strong frequent guest program are the necessary tools to taking market share. Room rates are just one of many criteria that hotel consumers weigh when deciding whether or not to stay at a particular hotel.

Frequent guest programs, which allow consumers to build points for future rewards, give customers an extra incentive as they know that building points will result in a “freebie” somewhere down the line. When deciding between two competing brands in comparable

The lodging business is becoming more automated.



locations and in comparable price points, the ability to build points will likely sway the undecided. We believe that those hotels that are not affiliated with a frequent guest program and have less well-regarded brand affiliations will likely lose market share to the more dominant competitors over time.

Brand leverage opportunities Over the past several years, the more traditional lodging companies have extended their operations into timeshare, corporate, and residential apartments. Branching into these markets allows lodging companies some insulation from lodging and travel cycles, and produces a more stable revenue stream. Extending the reach of their brands also adds to brand recognition and consumer preference. (See page 39 for the section entitled “A closer look at timeshare operations” for more details on this growing subsegment within lodging.)

Future domestic acquisition opportunities are niche-focused and relatively small Despite the recent wave of consolidation in the lodging sector, we believe acquisition opportunities still exist as several niche hotel competitors have recently proven the strengths of their business models. Smaller niche competitors focused on the high-end luxury segment are the likely targets.

In addition, we continue to believe that given the highly fragmented nature of the European hotel market, one-off acquisitions of hotel portfolios abroad are possible for some of our US-based hoteliers that are looking to build out their international presence. We have already started to see this happen with Hilton Corp’s acquisition of Hilton International in February 2006 and Starwood’s acquisition of the Le Meridien brand in November 2005.

Four Seasons, Marriott, Hilton, and Starwood all have active timeshare components and are starting to build out their residential component.



*New* Pricing power comparisons suggest hotels still have more to go; upside potential more significant for high-end hotels

Our recent pricing analysis of the lodging sector suggests that the hotel companies continue to have room to push rates and RevPAR over the next several years. In fact, according to our analysis, nominal hotel pricing at the end of 2005 was up just 6.5% from its 2000 peak, with a CAGR of just 1.3% over that five-year period, below the rate of inflation during that period of 2.5% per year. In real terms, average daily rates remain 6% below the peak levels achieved in 2000, leaving significant room for further rate increases (see Exhibit 12).

Exhibit 12: Lodging pricing analysis real RevPARs are forecast to rebound close to peak 2000 performance in 2006

2000 2001 2002 2003 2004 2005 2006E 05 vs peak CAGR (00-05) 06 vs peak CAGR (00-06E)

Lodging nominal RevPAR 53.99$ 50.25$ 48.90$ 49.09$ 52.93$ 57.34$ 61.75$ 6.2% 1.2% 14.4% 2.3%% change YOY 6.1% -6.9% -2.7% 0.4% 7.8% 8.3% 7.7%

Real RevPAR 53.99$ 48.87$ 46.81$ 45.96$ 48.26$ 50.56$ 52.77$ -6.3% -1.3% -2.3% -0.4%% change YOY 2.7% -9.5% -4.2% -1.8% 5.0% 4.8% 4.4%

ADR nominal $85.32 $84.18 $82.97 $83.08 $86.23 $90.84 96.11$ 6.5% 1.3% 12.6% 2.0%% change YOY 5.4% -1.3% -1.4% 0.1% 3.8% 5.3% 5.80%

Real ADR 85.32$ 81.86$ 79.43$ 77.77$ 78.62$ 80.10$ 82.13$ -6.1% -1.3% -3.7% -0.6%% change YOY 1.9% -4.1% -3.0% -2.1% 1.1% 1.9% 2.5%

Occupancy 63.3% 59.7% 58.9% 59.1% 61.3% 63.1% 64.3% -0.3% 1.6%bps change 43.7 -357.4 -76.5 16.0 220.5 180.0 110.0

CPI 172.2 177.1 179.9 184.0 188.9 195.3 201.5 13.4% 2.5% 17.0% 2.7%% change YOY 3.4% 2.8% 1.6% 2.3% 2.7% 3.4% 3.2%

Source: Smith Travel Research, Goldman Sachs Economic Research, and PricewaterhouseCoopers.

Pricing analysis findings We have analyzed hotel pricing in two different ways: (1) on a compound growth rate basis over the past five years, and (2) relative to the peak operating performance achieved in 2000. In 2005, hotel nominal RevPAR exceeded peak levels reached in 2000 ($57.34 versus $53.99) and showed a CAGR of just 1.2% over that five-year period. On the rate side, nominal ADR was up 6.5% compared with the peak. Adjusting the data for inflation delineates a stronger picture for our hotel companies, with real RevPAR and real ADR down over 6% compared to real levels achieved in 2000. We believe this provides our companies with significant leverage to continue boosting rates and fattening margins as rate improvements should drive the bulk of the RevPAR improvement over the next two to three years.

High-end hotels with most significant upside potential We have found that the high-end hotels in the luxury and upper upscale segments have the most potential for upside given the more drastic rate cuts implemented in the last downturn. As you can see in Exhibits 13 and 14, real rates declined three consecutive years from 2001 through 2003. Even with the recent rebound in rates, which began in

Business travelers are location sensitive and price insensitive, in our opinion, leading to pricing power when demand is high.

Even though prices have risen on a nominal basis, they have actually declined from the peak in real terms.



2004, average daily rates have only shown a CAGR of 0.8% and 0.3%, respectively, since 2005 for the luxury and upper-upscale segments.

On a real basis, rates in 2005 were 8.2% below the peak for luxury and 10.5% below the peak for upper upscale. Since most of our hotels’ profits are generated in the high-end segments, we believe that these data support our view of significant pricing potential ahead.

Exhibit 13: Luxury pricing analysis nominal ADR has shown a CAGR of just 0.8% over the past five years

Luxury 2000 2001 2002 2003 2004 2005 2006E 05 vs peak CAGR (00-05) 06 vs peak CAGR (00-06E)

Lodging nominal RevPAR 174.12$ 149.36$ 141.75$ 142.86$ 157.39$ 175.39$ 193.52$ 0.7% 0.1% 11.1% 1.8%% change YOY 9.0% -14.2% -5.1% 0.8% 10.2% 11.4% 10.2%


ADR nominal $240.38 $234.89 $224.73 $222.47 $233.25 $250.33 270.44$ 4.1% 0.8% 12.5% 2.0%% change YOY 8.5% -2.3% -4.3% -1.0% 4.8% 7.3% 8.20%


Occupancy 72.4% 63.6% 63.1% 64.2% 67.5% 70.1% 71.6% -3.3% -1.2%bps change 33.0 -884.5 -51.4 113.8 326.2 258.7 130.0

CPI 172.2 177.1 179.9 184.0 188.9 195.3 201.5 13.4% 2.5% 17.0% 2.7%% change YOY 3.4% 2.8% 1.6% 2.3% 2.7% 3.4% 3.2%


Exhibit 14: Upper upscale pricing analysis occupancy in 2006 is forecast to rebound back to its peak level achieved in 2000

Upper Upscale 2000 2001 2002 2003 2004 2005 2006E 05 vs peak CAGR (00-05) 06 vs peak CAGR (00-06E)

Lodging nominal RevPAR 100.48$ 88.78$ 85.83$ 84.27$ 91.16$ 100.06$ 109.06$ -0.4% -0.1% 8.5% 1.4%% change YOY 7.0% -11.6% -3.3% -1.8% 8.2% 9.8% 9.4%


ADR nominal $139.04 $135.22 $129.39 $126.97 $131.93 $141.11 150.67$ 1.5% 0.3% 8.4% 1.3%% change YOY 5.5% -2.7% -4.3% -1.9% 3.9% 7.0% 7.20%


Occupancy 72.3% 65.7% 66.3% 66.4% 69.1% 70.9% 72.4% -1.9% 0.2%bps change 102.4 -661.2 67.6 3.7 272.5 181.2 150.0

CPI 172.2 177.1 179.9 184.0 188.9 195.3 201.5 13.4% 2.5% 17.0% 2.7%% change YOY 3.4% 2.8% 1.6% 2.3% 2.7% 3.4% 3.2%


With growth in real prices low, even if consumers have sticker shock they are still booking rooms.



*New* A closer look at customer mix and its impact on hotel profitability

It is important to understand the various customer types that frequent hotels. Changes in customer mix can drastically alter a hotel’s profitability and its ability to drive last-minute rates in periods of high levels of demand.

There are three primary categories that customers can fall into

1. Group. Customers that fall into the group category include those that have been sold rooms simultaneously in blocks of a minimum of ten rooms or more. These customers include group tours, domestic and international groups, association, convention, and corporate groups.1

2. Contract. Customers in the contract category are those that pay a rate stipulated by contracts between the customer and the hotel including airline crews and permanent guests.2

3. Transient. Transient customers are those that pay rack, corporate, corporate negotiated, package, government, or foreign traveler rates. 3

Under a normalized operating environment, the customer mix of a standard full-service hotel is roughly 55% transient, 42% group, and 3% contract according to Marriott. In periods of much weaker demand, transient declines, and the group (particularly lower-rated group) and contract mix tends to increase (see Exhibits 15 and 16).

Exhibit 15: Full-service hotel customer mix during normalized operating environment transient customers comprise over half of the hotel stays

Exhibit 16: Full-service hotel customer mix during weak operating environment contract business typically increases

Transient55%

Group42%

Contract3%

Transient48%

Group44%

Contract8%

Source: Goldman Sachs Research. Source: Goldman Sachs Research.

1 Smith Travel Research.





In weak environments, hotels turn to associations and airline crews In a weak operating environment such as the post-September 11 period, we saw full-service customer mix change dramatically across the hotel industry. Full-service Marriotts, Sheratons, Westins, and Hiltons were forced to fill excess inventory with much lower-rated group business (sports teams, associations, weddings, etc.) and even-lower-rated contract business (i.e., airline crews). In fact, contract business, which typically garners just 3% share, grew to roughly 8% share across the Marriott brand. Full-service hotel managers turn to airline crews because they book blocks of rooms weeks at a time. The hotels are willing to cut rates on the weekdays for the airline crews, so that they can pick up much-needed occupancy on the weekend. Some airline crews enjoyed $70 per night rates at many full-service hotels during the downturn compared to the above $150 rates that the hotels were accustomed to.

In a recovering lodging environment, mix shifts occur in three ways As the lodging recovery has continued we have seen significant changes in customer mix between group, transient, and contract and within the transient and group segments themselves. In this next section we walk you through the major customer mix changes that are currently under way and how they are leading to immediate and meaningful increases in profitability at the hotel level.

1. Shift in mix between contract, group, and transient The first most noticeable shift in mix that has occurred is the decline in contract and lower-rated group business and the subsequent increase in higher-rated group and transient business. This is a slow evolution as many full-service hotels lock in contract and lower-rated group deals several years in advance. Nonetheless the shift is continuing as contract business has pulled back to the low-single-digit range from the high-single-range as a percentage of overall bookings.

To put this mix shift into perspective, we asked Marriott what the differential in hotel rates was between contract, group, and transient business under a normalized operating environment at their Marriott full-service brand. For the Marriott brand on average group rates range from the high $200s to $300 per night, contract rates are in the $70-$150 range, and transient rates are in the $400-$500 range. It is apparent from these pricing differentials how impactful a mix shift from contract ($70 per night stay from an airline crew member) to transient (over $400 per night from a high-paying business customer) can be at the hotel level. It also helps to explain the high rate increases that we have and should continue to see over the next few years.

2. Shift in mix within transient segment The second major customer mix change that is occurring is within the transient segment itself. The transient segment is divided by three primary rate types: corporate, rack, and special corporate/discounted. The typical corporate rate is the nonqualified, nonrestrictive rate that most customers off the street would pay. Special corporate/discounted rates, however, are given to a hotel companies’ largest customers who guarantee significant levels of hotel usage. These rates can be as much as 20%-30% cheaper than the standard corporate rates due to the large inventory guarantees. Rack

Contract bookings increase in weak operating environments as hotel companies look to fill occupancies at all cost.

The highest-paying hotel customers are typically business transient customers who pay $400-$500 per night on average.



rates are premium rates for King suites, premium packages, water-view rooms, etc. Assuming a $100 benchmark corporate rate, the special corporate/discounted rate would be approximately $70-$75 with a rack rate of $115.

In weak operating environments, the hotels tend to have a higher percentage of special corporate/discounted rates in an attempt to lock in rates for the future. Under a more normalized operating environment, special corporate/discounted consume approximately 25% of all transient bookings or 10%-15% of total bookings. The major hotel companies have significantly pulled back on special corporate/discounted rates as RevPARs have rebounded over the past two years. Given the 20%-30% rate discounts, the shift from special corporate/discounted to more premium rack and corporate rates is having a meaningful and immediate impact on the hotels’ bottom lines currently and should continue to do so as this mix shift continues.

3. Shift to higher-paying last-minute groups The last mix shift that is occurring is to higher-paying last-minute groups. This mix shift is occurring at the hotel level and also between hotels. Groups are finding that they have to “pay up” to have group meetings. Group meeting planners who had previously expected to call in to get a “group discount” on rooms are finding themselves surprised when offered rates close to corporate and rack rates. Hotels are holding back inventories and groups are finding themselves either paying up or shifting meetings to other hotels in cheaper markets.

Special corporate rates are typically 20%-30% cheaper than standard corporate rates and are given to hotel companies largest customers.

Group meeting planners are getting limited discounts on last-minute group bookings.



*New* Returns on new hotel development remain low

According to PricewaterhouseCoopers, current US supply growth forecast for the next two years remains low at 1.1% for 2006 and 2.0% for 2007. High-end supply growth is also forecast to remain in check, with luxury supply estimated to be up just 1.4% and 2.3% and upper upscale supply up 1.4% and 2.2% in 2006 and 2007, respectively.

We think one of the main reasons supply will continue to be held in check, particularly for the high-end segments, is the low unlevered returns on new hotel development, which are currently running in the 7%-8% range according to Marriott International. Construction and raw material costs continue to increase, putting pressure on returns, and it does not appear that the dynamics for additional hotel development will improve over the near term.

Construction costs are outpacing robust RevPAR gains, keeping return metrics low As we discussed above unlevered returns on new build hotel projects are currently running in the 7%-8% range, with levered returns in the low- to mid-teens range. According to Marriott International, it would take unlevered returns in the 10%-12% range and levered returns in the 18%-20% range before developers would start to get more aggressive.

The main hindrance to higher returns at this point is not the operating performance (RevPAR trends have been solid, up 7.8% in 2004 and 8.4% in 2005), but significant rise in construction costs and other expenses. Construction costs escalated in 2004 up 10.5% on average only to be followed by an additional 6.5% increase in 2005 and estimated 4%-6% increase in 2006, according to Marriott International. Recent hurricanes and high demand from China and other growing economies are keeping construction and raw material costs high. In addition construction services (i.e., labor, construction managers) are being stretched as rebuilding efforts continue throughout the country from recent hurricane activity.

Majority of new high-end hotels are currently mixed use The small number of high-end hotels that are being built are either (1) mixed-use hotels with hotel rooms, residential apartments, condos, and timeshare units, or (2) hotels receiving government or other subsidies.

The shift toward these mixed-use projects is primarily a result of the higher return metrics given the strong real estate market. Unlevered returns on mixed-use hotel projects are currently in the high teens, with levered returns in the mid-25% range. Developers continue to turn to these mixed-use projects, even taking existing hotel room inventory out of the market to convert to apartments, condos, timeshare, or even retail space. A good example of this is Strategic Hotels & Resorts’ plans for its two recently acquired Fairmont Chicago and InterContinental Chicago hotels. Strategic has laid out its proposed plans to eliminate 113 rooms in the Fairmont Chicago as it reconfigures and converts its existing floor plan to hotels, condos, and residential club units. In addition, it has plans to lower the overall hotel room count at the InterContinental Chicago from 807 to just 480, as it hopes to increase retail space and add 310 luxury condo units.

We focus on supply growth in the high-end segments given that our hotel companies derive the majority of their profits from high-end hotels.

Although US industry RevPAR increased 7.8% in 2004 and 8.4% in 2005, it has not been enough to offset the 10.5% and 6.5% increases in construction costs in 2004 and 2005, respectively.

The mixed-use hotel product appears to be here to stay, as high-end hotel developers do not appear interested in building the standard 400-500 room hotel anymore.



The other high-end hotels that are being built seem to be those that are getting help monetarily from governments and other interested parties. We think this is the only way that many developers can achieve the required return hurdles to build. According to lodging managements, they continue to see more and more governments put in additional money to help push through hotel projects that will add much-needed convention space and or hotel rooms to their respective markets.

A closer look at returns In this section we lay out an example of a new hotel project and how we derive an 8% return. In this example we estimate a high-end hotel costs roughly $75 million to build including all land and construction costs. We assume a 350-room hotel with $150 average daily rate and 72% occupancy level once it reaches stabilization, which typically takes one to two years on average. As with most hotels, it takes time for the hotel to start paying incentive fees. In this example, this hotel has not yet reached a net house profit that would allow it to pay an incentive fee (see Exhibit 17).

Exhibit 17: Returns on new hotel builds remain low

Full Service HotelTotal Cost including land and construction $75 millionTotal Rooms 350Cost per room $214,286

Assumptions for stabilized propertyADR $150Occupancy 72%RevPAR $108

($ in thousands) Managed Property

Room revenue $13,797Food and Beverage (approx. 60% of room revenue) $8,278Total Revenue $22,075

Net House Profit before base fee (30%) $6,623Base fee (3% of revenues) $662Net House Profit $5,960

Owner's Priority (10.5% of total cost) $7,875Cash Available for incentive fee $0Incentive management fee (20%, but could be higher) $0

Owner's return (unlevered)Net House Profit $5,960Less incentive management fee $0Cash to Owner $5,960Cash on cash return (unlevered) 8%

Source: Marriott International and Goldman Sachs Research.

Levered returns would be more in the 10%-12% range currently.



*New* Big Three lodging companies continue to evolve

The Big Three hotel companies (Marriott, Starwood, Hilton) continue to lessen real estate exposure and focus more and more operations on the high-recurring, less capital intensive management and franchise fee streams domestically and abroad. This should lead to higher free cash flow generation, improving returns, higher unit growth potential, more stable earnings results, and ultimately higher valuations over time, in our opinion.

Marriott was the first company to make the move away from hotel ownership, with the spin-off of a majority of its owned hotel portfolio to create what is now known as Host Hotels & Resorts. Starwood and Hilton are now following suit, continuing to sell down their asset-heavy portfolios while maintaining long-term management and franchise agreements.

Focus on international expansion The continued evolution of our hotel companies to a more management and franchise fee-focused model comes at a time when our companies are also expanding internationally. Hilton just jump-started its international expansion with the $5.960 billion acquisition of Hilton International, Starwood enhanced its exposure with the purchase of the Le Meridien brand in late 2005, and the pipeline for the Big Three is increasingly focused on China, India, Europe, and the Middle East.

In this section we examine the progression of Marriott, Starwood, and Hilton from domestic, ownership companies to more fee-driven (management and franchised) enterprises with an inclination for international growth. We also lay out what the Big Three could look like in 2010.

We think the move toward more management and franchise operations could lead to higher valuations for Starwood and Hilton over time.



Marriott has set the standard as a fee-based operator Out of the Big Three hotel companies, Marriott was ahead of the curve with its fee-based focus as the company spun out its owned assets to form Host Marriott (now Host Hotels & Resorts) in 1993. Since that time, Marriott has selectively owned hotels, but the contribution to total revenues has been significantly less than Starwood and Hilton. In 2001, Marriott derived just 32% of revenue from owned/leased operations compared to over 70% for Starwood and Hilton (see Exhibit 18). Since 2001, Marriott has reduced its ownership exposure by more than 700 bp as the company has sold off additional hotels.

Total portfolio is forecast to increase 23% by 2010 Over the next couple of years, we estimate that Marriott could add approximately 25,000 rooms annually, reaching over 600,000 rooms by 2010 for a 4.7% CAGR.

Marriott’s international mix is on the rise We estimate that Marriott’s international mix of hotels could increase to roughly 23% of the total portfolio by 2010 from the current 20% range. We would point out that its international exposure was much higher in 2001, but declined given the sale of Ramada International to Cendant Corp in 2004.

Exhibit 18: Marriott International…then, now, and estimated future portfolio snapshots Marriott could grow its global room base by 25% from 2006 to 2010

14.7% 8.7% 8.0% 31.7% 36.9% 16.0% 10.4% 6.9% 24.3% 42.5% 16.5% 11.4% 8.8% 15.4% 47.9%

TimeshareMgmt Franchise Incentive Owned

US non-US

77% 23%

FUTURE

2010

10: Marriott, Ritz-Carlton, Renaissance, Bulgari, JW Marriott, Residence Inn, Courtyard, Springhill Suites, TownePlace Suites,

Fairfield

610,979

Assumes 25,000 rooms/year ( 4.7% CAGR)

THEN NOW

Number of Hotel Brands11: Marriott, Ritz-Carlton, Renaissance, Bulgari, JW Marriott,

Residence Inn, Courtyard, Springhill Suites, TownePlace Suites, Fairfield, Ramada International

2001 1Q06/06E

10: Marriott, Ritz-Carlton, Renaissance, Bulgari, JW Marriott, Residence Inn, Courtyard, Springhill Suites, TownePlace Suites,

Fairfield

Room Count 427,489 491,283

Pipeline 70,000 rooms 70,000 rooms

non-US

Leverage62%

61% 39% 80% 20%

Mgmt Franchise Incentive

79% 1.3X

Portfolio Mix

US non-US US

Owned Timeshare

Valuation

Net Debt to EBITDA Debt to Equity Net Debt to EBITDA

Forward PE EV/EBITDA

23.2X 11.9X

Forward PE

2.59X

EV/EBITDA

23.7X 13.4X

Owned TimeshareMgmt Franchise Incentive

Debt to Equity

Rooms

Revenues (ex reimbursed cost)

Source: Company reports and Goldman Sachs Research.

Currently Marriott owns just 17 hotels comprising just 1 % of its total portfolio.



Starwood rapidly evolving to asset-light business model Following the recent sale of 35 hotels to Host Hotels & Resorts and the 2005 acquisition of the Le Meridien brand, Starwood significantly reduced its owned EBITDA exposure from about 59% to 38%. The company will continue to lighten its owned contribution and intends to sell another $500 million-$1 billion in assets over the next 12-18 months. The new Starwood is more similar to Marriott, with 36% of its EBITDA coming from fees compared to under 20% back in 2001. One distinct characteristic of Starwood’s evolving portfolio is the significant international exposure, with approximately 44% of the company’s rooms outside of North America currently compared to just 33% five years ago.

Starwood is estimating 5%-7% annualized unit growth through 2009 In the next three to four years, Starwood is embarking upon an aggressive unit growth plan and hopes to open 50 hotels in 2006, 60-70 in 2007, 80-90 in 2008, and 90-100 in 2009; during this time the company plans on removing roughly 50-75 hotels. We believe that the company will open a net 16,000 rooms on average per year over the next five years and could get to over 320,000 rooms by 2010. This would increase its total global room count by roughly 33% in just five years (see Exhibit 19).

Exhibit 19: Starwood Hotels & Resorts…then, now, and estimated future portfolio snapshots Starwood is reducing its owned exposure with over $5 billion hotel assets sold in the past 12-18 months.

26.0% 30.4%24.8% 44.8%

Rest of World

59% 41%

Owned/Leased Fee Business Timeshare/Other

FUTURE

2010

8: St. Regis, Luxury Collection, Sheraton, Westin, W, Le Meridien, W Aloft and Four Points.

Assumes 16,000 rooms/year on average ( 6% CAGR)

321,448

EV/EBITDA

26.5X 12.4X

Timeshare/OtherFee Business

Debt to Equity

Rest of World North America

Valuation


Forward PE EV/EBITDA

17.7X 7.8X

Forward PE

4.4X 147% 1.5X

North America

Owned/Leased

79.5%

Other

20.5%

Owned/Leased

38.0%

Leverage100%

67% 33% 56% 44%

Portfolio Mix

North America Rest of World

36.0%

Room Count 224,467 240,448

Pipeline NA 76,000

THEN NOW

Number of Hotel Brands6: St. Regis, Luxury Collection, Sheraton, Westin, W and Four

Points.

2001 1Q06/06E

8: St. Regis, Luxury Collection, Sheraton, Westin, W, Le Meridien, W Aloft and Four Points.

Rooms

EBITDA


Starwood is in the midst of a major asset disposition program.

Starwood’s debt levels have declined while at the same time operations are moving toward a more free cash flow generation model.



Hilton has gained access to international markets with acquisition of Hilton International

Since Hilton Hotels sold the rights to the Hilton brand internationally in 1964, the company has been precluded from developing the Hilton brand outside of the United States. Aside from a joint-venture to develop Conrad hotels with Hilton International, the company was solely focused on building out its suite of brands in the United States. The recent acquisition of International’s hotels for $5.96 billion changed the game and Hilton’s portfolio is now 81% exposed to the US compared to 100% before the deal (see Exhibit 20).

Hilton has levered up near term with its recent acquisition Although Hilton’s long-term plan is to sell down the 40 assets recently acquired from International, the company’s current mix is 59% exposed to owned/leased hotels compared to about 50% before the acquisition, based on EBITDA. Hilton’s exposure to fees dropped 600 bp to 33% and timeshare now will contribute 8% of EBITDA down from 11% previously. Management has stated that it will be in the market selling the Hilton International assets and we expect the owned/leased exposure to drop significantly, with a corresponding increase to the company’s management and franchise business.

Robust pipeline with significant global expansion potential Looking ahead, Hilton has the strongest pipeline of the Big Three, with over 100,000 rooms slated for development or about 30%-40% more than Starwood and Marriott, respectively. We estimate that Hilton will be able to open about 35,000 rooms per year and will likely surpass Marriott’s room count in 2006; by 2010 we expect that Hilton could operate over 650,000 rooms for a 6.2% CAGR from 2006.

Exhibit 20: Hilton Hotels…then, now, and estimated future portfolio snapshots Hilton Hotels has gone global with its purchase of Hilton International in January 2006

11% 43% 16% 8% 28% 11% 11%

EV/EBITDA

25.2X 11.4X

Timeshare/OtherFee BusinessOwned Leased

Debt to Equity

33%

Valuation


Forward PE* EV/EBITDA

24.8X 9.7X

Forward PE

2.0X 129% 4.8X

Americas

Owned

50%

Fee Business Timeshare

39%

Rest of World

Leverage295%

100% 0% 81% 19%

Portfolio Mix

Americas Rest of World

Room Count 374,669 486,767

Pipeline 78,000 100,000

THEN NOW

Number of Hotel Brands7: Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Homewood

Suites, Hampton Inn, Conrad

2005 1Q06/06E

8: Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Homewood Suites, Hampton Inn, Conrad, Scandic

FUTURE

2010

8: Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Homewood Suites, Hampton Inn, Conrad, Scandic

Assumes 35,000 rooms/year ( 6.5% CAGR)

651,558

Americas Rest of World

79% 21%

Fee Business Timeshare/OtherOwned Leased

50%

Rooms

EBITDA


Hilton currently sports the largest development pipeline, with over 100,000 rooms.



A closer look at international expansion opportunities

Given our hotel companies’ desires to expand internationally, It is important for investors to understand the global lodging market. In this section we take a close look at European hotel market characteristics, detailing the challenges that our companies may face as they look to accelerate international expansion.

Brand penetration is low, but opportunities are plentiful in European hotel market

Ability to grow units in Europe is high but will be challenging We believe that the ability to grow units in Europe is high, with an estimated 4.6 million hotel rooms (does not include Eastern Europe). Although Europe has more hotel rooms than the US (4.5 million), only 23% of all rooms (about 1.1 million) are branded. The remaining 77% or 3.5 million are independent or unaffiliated hotels that are not under a unified brand. This is in contrast to the US market, where roughly 70% of its 4.5 million hotel rooms are under a unified brand. If we assume that the European market will one day be as branded as the US market, at roughly 70%, that opens up almost 2.2 million hotel rooms as potential conversion opportunities for our US-based hotel companies.

There is a wide dispersion of brands Given the high fragmentation of the European market the questions of where the US companies should expand to get distribution is difficult. It is not easy to acquire a chain or entire hotel company to get distribution as few brands are represented in more than one country.

The greatest sales potential is in Italy The leading European hotel markets in terms of annual hotel sales are (1) Italy: roughly 22.9 billion EUR; (2) France: roughly 14.2 billion EUR; (3) United Kingdom: roughly 13.1 billion EUR; (4) Germany: roughly 11.8 billion EUR; and (5) Spain: roughly 7.9 billion EUR (see Exhibit 21).

Although Italy may provide the most potential in terms of hotel sales, brand penetration in this market is extremely low at less than 10%. In Spain and Germany, approximately 10% to 35% of the hotels are branded and the United Kingdom and France have the highest brand penetration at greater than 35% (see Exhibit 22). Although there is significant potential in these markets, the fragmentation will make increasing market share a daunting task for our US-based hoteliers as they will likely have to do numerous deals with numerous hotel owners and developers to gain critical mass within a respective country or region.

The Western European hotel market has roughly 4.6 million hotel rooms.

Italy is less than 10% branded. The lack of a cohesive brand makes acquiring a position in the market difficult.



Exhibit 21: Size of Western European hotel market, measured by total revenues hotel sales, all hotels; EUR mn, constant exchange rates

1999 2000 2001 2002 2003 2004

Italy 21,857.30 22,963.20 23,921.70 23,879.00 23,603.40 22,935.70France 13,587.00 14,103.00 14,301.00 14,103.00 14,095.00 14,197.00United Kingdom 11,954.10 13,340.80 13,295.90 13,611.10 12,624.90 13,194.90Germany 12,232.20 13,009.60 12,837.60 12,215.10 11,726.50 11,843.70Spain 6,703.30 7,454.00 7,740.60 7,791.20 7,941.20 7,932.50Austria 3,009.90 3,218.40 3,494.90 3,855.10 3,978.40 4,160.40Greece 1,138.80 1,305.40 1,465.40 1,583.50 1,706.70 2,180.70Netherlands 2,044.00 2,130.50 2,096.90 2,157.70 2,032.30 2,062.00Switzerland 2,126.40 2,304.50 2,242.50 2,126.90 2,016.40 1,998.80Turkey 735 1,235.20 1,680.50 1,879.20 1,708.10 1,809.80Finland 1,311.90 1,382.30 1,450.00 1,456.80 1,458.40 1,459.50Belgium 1,264.30 1,344.50 1,395.60 1,325.00 1,305.90 1,320.00Norway 1,384.40 1,409.70 1,369.50 1,458.80 1,359.80 1,314.80Ireland 1,061.30 1,290.80 1,181.10 1,228.20 1,294.80 1,292.00Sweden 1,199.70 1,352.70 1,294.10 1,306.90 1,288.40 1,282.70Portugal 732.9 832 906.6 861.3 867.2 998Denmark 821.9 852.2 857.2 879.8 908.1 914.2Other Western Europe 267.7 298.7 308.7 321.3 322.7 362.9

Total 83,432 89,828 91,840 92,040 90,238 91,260Growth 7.7% 2.2% 0.2% -2.0% 1.1%

Source: Euromonitor.



Exhibit 22: Brand penetration among EU member states 74% of the EU members have brand penetration that is less than 35%

Source: MKG Consulting (January 2005).

Our hotel companies are beginning to do international deals Despite the many hurdles to European expansion, Marriott, Starwood, and Hilton are very active in the European market. Starwood recently acquired the Le Meridien brand, which added 124 hotels to its portfolio and gave it much-needed exposure to key international gateway cities throughout Europe, the Middle East, Central Asia, and Asia Pacific.

Just last year, Marriott closed on a deal with Whitbred PLC to form a 50-50 joint venture to acquire Whitbred’s portfolio of 46 franchised Marriott and Renaissance hotels, all located internationally. This deal gave Marriott more control at the property level and helped to build its footprint throughout Europe.

And perhaps the most influential deal was Hilton Corp.’s acquisition of Hilton International. Previously Hilton Corp. was unable to expand outside of North America given its agreement with Hilton International. With the acquisition, Hilton Corp. has increased its portfolio 28% and has jump-started its global expansion.



A closer look at timeshare operations

Timeshare or vacation ownership is a fast-growing subset of our lodging companies’ operations, comprising roughly 20% of overall revenues for Starwood, over 40% for Marriott given its core management focus, and less than 15% for HLT following its acquisition of Hilton International. We expect timeshare revenues as a percentage of overall revenues will grow over the next several years, with closer brand affiliation, increased customer acceptance, and continued leisure travel expansion.

We view the shift toward more timeshare revenues as a positive; with leisure travel driving a bigger portion of overall earnings, our companies would be less dependent on the more cyclical business component. Currently, roughly 70% of our hotel companies’ earnings come from business travel, but it is the timeshare and leisure side of operations that kept the hotel companies afloat following the most recent downturn.

With timeshare sales solid and our hotel companies’ continued investment in the sector, we take a closer look at how the industry has evolved, the industry dynamics, the positives and the negatives of timeshare ownership, and how our hotel companies make money in this business.

Quick timeshare review Timeshare or vacation ownership typically entitles a buyer to the use of a fully furnished condominium-style residence located in a vacation/tourist destination, generally for a one-week period each year, known as a vacation interval. In addition, fractional ownership interests are also available for 5-26 weeks at a time. These condo-type units are superior in quality to a hotel room in the amount of space (typically two to three bedrooms) and level of amenities (full kitchen and appliances). The only downside is service, which is sometimes less compared to a hotel stay.

The benefit to vacation ownership is that it allows consumers to purchase an interval that guarantees them a unit at a specified time of year in a specific location at a fraction of full ownership. Consumers pay a one-time purchase price for the interval in addition to annual maintenance fees which are on average $325 per year.

In addition, consumers with interval ownership have the right to exchange their interval for another within the same system or outside the system via an interval exchange company such as RCI or Interval International. This allows the consumer to potentially change locations on an annual basis providing a lifetime of vacations at different locales. Consumers with a Marriott, Hilton, Starwood, or Cendant (Trendwest and Fairfield brands) timeshare interval have the ability to exchange their interval for points in the respective frequent guest programs, which allow the consumers to stay in any hotel in the system.

Industry facts According to the American Resort and Development Association, the timeshare industry has over 5,425 resorts located in 95 countries. Annual timeshare sales are approximately $11 billion globally and over $8 billion in the US alone. Our hotel companies Marriott,

Even though timeshare has been around for over 30 years, market penetration of this vacation product remains low, with just 5%-7% of qualified US consumers owning a timeshare interval.



Starwood, and Hilton comprised roughly $3.2 billion in timeshare sales in 2005 and account for 2% of the resorts and 5% of the timeshare units available.

Other key industry participants in timeshare include Cendant, with its Trendwest and Fairfield brands, and the independent timeshare companies Bluegreen and Sunterra.

Timeshare industry has slowly evolved into a high-quality brand affiliated resort product

In the late 1980s the timeshare, or vacation ownership industry, was a relatively underpenetrated industry growing in the low teens. Over the past 25 years, however, we have seen the timeshare industry evolve from a relatively fragmented and underpenetrated business to a higher-quality, brand-affiliated resort product driven by Marriott, Starwood, Hilton, Four Seasons, and Cendant.

During the most recent economic downturn, the timeshare industry showed above-average growth of 15%, driven by a strong leisure traveler. As we discussed above, this strength in timeshare helped to offset the more significant declines in the core lodging business for the major hotel companies.

Timeshare operations are getting more attention because they are bigger and more clearly defined

The timeshare or vacation ownership model has been around for over 30 years, but admittedly this segment of the public lodging companies’ financials has not gotten a lot of attention up until just a few years ago. The main reason being that timeshare revenues still remain a relatively modest percentage (20% on average for Starwood and less than 15% for Hilton) of overall revenues and profits, but increasingly they are becoming more of a “swing factor” in quarterly results. For Marriott, its timeshare contribution is more pronounced, with timeshare revenues comprising over 40% of sales excluding cost reimbursements and roughly 18% of profits in 2005. We think the timeshare contribution will get more attention going forward given its increasing impact to overall results.

The second reason behind timeshare not getting as much attention as it deserves in the past is that lodging operators really just began to break out timeshare contribution in 2003. In fact, up until 2003, most lodging companies included their timeshare revenues and profits in the “other” line item, which served as a catchall for timeshare-related business, franchise and management fees, and gains on sales of hotels and notes receivables. As a result, it was difficult for investors to closely analyze this segment of overall operations.

The positives of timeshare for a hotel company As we discussed above, we believe that continued growth in timeshare is a long-term positive for our hotel companies for the following reasons: (1) it is a natural hedge against a decline in business travel, (2) it is a natural add-on to the core lodging business, (3) it is a relatively underpenetrated product, (4) there are expectations of margin improvements, and (5) it has favorable industry dynamics.

Bluegreen (BXG) and Sunterra (SNRR) are independent timeshare companies.

Timeshare earnings have proven to be “cyclically resistant” during the past economic downturn.

Only in the past two years have the hotel companies begun to break out timeshare revenues.



Timeshare is a natural hedge against changes in business travel Over the recent economic downturn it has become apparent that the timeshare business, which is leisure oriented, can serve as a hedge against the decline in business travel. In fact, the strength in the timeshare industry over the past several years has helped to boost the bottom lines of our major hotel companies. Timeshare revenues for Marriott, Hilton, and Starwood were up an impressive 15%, 39%, and 32%, respectively, in 2005 alone.

Our hotel companies derive roughly 70% of overall profits from business travel, so any added leisure exposure through timeshare participation is a growing benefit for the near and long term, in our opinion.

Timeshare is a natural add-on to the core lodging business We believe there are three reasons timeshare is a natural-add on to the core lodging business: (1) marketing penetration of timeshare is increased due to brand affiliation, (2) there is an increased utilization of hotel amenities by timeshare guests, and (3) there is an increase in the use of excess land and room inventory at the existing hotel.

First, the advantages from a marketing presence are significant for timeshare. Since timeshare is “sold” not bought, one of the biggest marketing expenses is to get customers in the door. In addition, given some of the negative publicity of the past, having a brand affiliation helps to reduce customers’ fear of the product.

Starwood, Hilton, and Marriott all aggressively data mine their frequent guest lists to prospect for customers. The result is that Marriott’s and Hilton’s marketing expenses on average are in the 40%-45% range, with Starwood in the 36%-39% range, which we estimate is lower than the broader industry. In addition, the brand name over the door signals to the consumers that the product is backed by the hotel company, which is unlikely to disappear.

We believe this marketing advantage has led to higher customer penetration and has enabled the branded hotel companies to build market shares at a more rapid pace relative to the independent timeshare operators who are not affiliated with a larger hotel brand.

Second, the synergistic benefits of developing a timeshare component adjacent to an existing hotel are significant given that common areas such as the pool, recreational activities such as golf and spa facilities, and restaurants can all be shared. The close proximity of the timeshare component with the existing hotel leads to incremental consumer spend and greater expense sharing across a larger base, which helps to enhance the existing hotel’s profitability.

For example, at most business hotels the pool is rarely used by guests and most of the restaurants are used only in the morning and late evening. However, timeshare guests tend to be more leisure oriented. They spend more time at the hotel and typically will use and pay for more amenities. In general, we believe that timeshare customers increase utilization of the hotel’s amenities during the down times.

And third, timeshare allows for mixed use and further development opportunities. Hotel owners increasingly look at their excess room inventory as conversion opportunity. Rather than leave empty rooms, which reduce occupancy rates, raise expenses, and lower

Brand affiliation in timeshare adds a level of legitimacy to the product.

We continue to see more real estate developers looking into timeshare.



pricing power, more and more hotel owners are deciding to convert portions of their room product to timeshare.

These conversion opportunities not only turn excess space into revenues, but return capital out of the investment. In addition, some excess real estate may not be ideal for hotel expansion given distance for checking in and for other business amenities, but it might be perfect for timeshare where interaction with guests and management is typically less.

Timeshare is a relatively underpenetrated product Timeshare remains a relatively underpenetrated product. Only 5%-7% of the qualified US population owns a timeshare product, leaving this subsector of the lodging market virtually untapped at the current time. We think market penetration will grow with increased consumer acceptance.

Expectations of margin improvement Admittedly profit margins have been pressured over the past two years given higher product and sales and marketing costs. In a more normalized operating environment product costs are roughly 40%, with sales and marketing an additional 40%, leaving profit margins in the 20% range. With the pressures of the economic slowdown in 2000 product costs and sales and marketing costs increased, resulting in margin compression to the mid- to low teens over the past three years. There is an expectation that margins will improve over the near term as (1) closure rates improve as the hotel companies work to prescreen potential buyers, and (2) more inventory comes online, allowing the hotel companies to leverage fixed costs over a larger base.

Timeshare has strong industry fundamentals The fundamentals of the timeshare industry as a whole are solid, with sales over $8 billion in the US in 2004. In addition, the industry has a number of additional factors that make it compelling: (1) attractive customer demographics, with median household income of $85,000 and higher-than-average education, (2) an added legitimacy over the past five years as well-established brands such as Marriott, Starwood, Hilton, Disney, Four Seasons, and Cendant brands Trendwest and Fairfield have grown their portfolios and increased awareness of the product, (3) global distribution, with over 5,425 resorts worldwide and over 325,000 units, and (4) high product satisfaction, with 40% of customers owning timeshare buying into second projects and over 85% saying they are satisfied with the product according to the American Resort and Development Association.

The negatives of timeshare Despite the positives above, there are negatives to our hotel companies’ timeshare operations. These include: (1) high risks on the capital structure side, (2) high selling pressures to move the product can result in potential reputational risk, (3) negative impact on return metrics, (4) potential earnings variability, and (5) significant margin pressure given high sales and marketing costs.

Project costs for timeshare are high, running at over 30% of sales.



The risks on the capital structure side are significant The risk on the capital structure side for our hotel companies is significant in timeshare, as hotels need to put up capital up-front and, in some cases, give loans to consumers. Marriott, Starwood, and Hilton have accelerated their timeshare investments, with each spending at least $100 million annually.

In addition, timeshare developers also take risks on the loans to timeshare owners as the hotel companies carry these loans on their books for some time. Since over 65% of customers use financing to buy timeshare, the hotel companies need to “package” these loans and sell them to other investors. Before they sell the loans there is some default risk and sometimes after they sell the loans there is still some residual default risk if the timeshare owners renege on their loans. Another risk is that there is a fine line between aggressive and obnoxious when selling, which creates a reputational risk for the brand.

Timeshare selling has historically been high pressure Nearly all of the salespeople in timeshare are commission based and have huge incentives to sell more units. This may conflict with the hotel companies’ focus on treating customers in a friendly and low-key manner. Even with the extensive training individual salespeople still make mistakes, which can ultimately hurt the brand image. This can happen to some of the hotels’ best customers since timeshare salespeople are data mining the brand’s frequent guest program.

Timeshare lowers overall return metrics The addition of timeshare lowers overall return metrics for our lodging companies. On average we estimate timeshare returns on invested capital are currently in the 6%-7% range for the major hotel companies. Returns on average are minimal in the first two to three years of a timeshare project given (1) delayed revenue recognition due to percentage of completion accounting, and (2) slow maturation of timeshare properties, which typically do not come into prime selling season for three to four years on major projects.

Timeshare earnings can be variable In the past, we have been concerned that timeshare revenues would be lumpy as properties either sold out quicker than expected or sold below expectations. This timing issue can result in robust timeshare revenues in one quarter and a deceleration in the following period without additional inventory to sell. To the hotel companies’ credit, they have done a good job managing their inventory as revenues on average have been relatively stable on a year-over-year basis.

This is likely a result of (1) ongoing and consistent replenishments in interval inventory with new projects and conversions of existing hotel products to timeshare product and (2) timeshare accounting, whereby timeshare revenues are recognized on a percentage of completion basis. If a timeshare resort is sold out in the first day, those revenues cannot be booked until the project is at least 10% complete, and at that time hotel companies can only book 10% of the revenues. As more and more of the project is built, the hotel companies can recognize revenue.

We estimate returns on timeshare developments are only in the mid- to high single-digit range.



In addition, earnings variability can result with the securitizaton of loans, which result in one-time gains on sale. Marriott appears to be the most active hotel company in loan securitization. In an effort to smooth out earnings and to address investors’ concerns that Marriott was using loan securitizations to “make” a quarter, Marriott now only records gains on notes receivable sales in the second and fourth quarters.

High marketing costs can pressure profit margins Marketing costs have always been high in the timeshare industry, with marketing dollars ranging from about 40%-45% of sales. Over the past two years it has become apparent that more and more marketing dollars are needed to close a sale as top-line revenues have increased at a higher rate than overall profits. As discussed above, there is an expectation that margins will improve as companies have started to combat freeloading consumers by prescreening potential buyers before offering free vacations and other incentives. In addition, as more inventory comes online, the hotel companies should begin to leverage the fixed costs, resulting in an increase in margins.

How hotel companies make money off timeshare The hotel companies make money off timeshare operations through (1) selling timeshare intervals, (2) financing interval purchases, and (3) resort operations.

• Selling timeshare intervals. The hotel companies make roughly 70%-75% of their timeshare revenues through selling the interval. Product costs on average are 40% of revenues, with selling and marketing costs of roughly 40%, leading to a 20% margin in a more normalized operating environment. We have seen an increase in marketing and sales costs over the past two years, with sales and marketing expenses as high as 45% in some cases. The overall trend for Marriott, Starwood, and Hilton vacation product is a continued increase in the average selling price as well.

• Financing revenues. The hotel companies also make money through financing the purchase of timeshare intervals. On average over 65% of timeshare owners finance their timeshare intervals. Consumers will typically finance up to 90% of the timeshare purchase price. The hotel company makes money on the spread between the cost of debt and the average financing rate it charges its timeshare purchasers. In addition, the hotel companies also have the ability to securitize the notes receivable, which typically results in periodic note sale gains. This allows the hotel companies to more quickly recycle capital to fund more buyers. For Hilton roughly 7% of its timeshare revenues are from this source. We forecast a higher percentage for Marriott of roughly 10%-15% given its periodic timeshare note receivable sales.

• Resort operations. The hotel companies also receive fees from existing timeshare owners to manage the timeshare resorts. These fees are taken out of the annual maintenance fees that timeshare owners are required to pay. Resort operations account for roughly 5%-10% of timeshare revenues on average.



Hotels have neutralized Internet threat

We believe that the Internet is a net positive for the lodging sector, as it is leading to higher net revenues per booking as consumers continue to shift hotel bookings toward the branded websites and away from the more expensive distribution channels (offline travel agents, 1-800 call centers, calling hotel directly). The Internet is just one more reason why we think margins should continue to go higher in this industry.

In this section, we list the major trends from our most recent pricing survey that support this view followed by a more detailed analysis of why we believe the hotels have neutralized the Internet threat.

Major trends from our most recent pricing survey • Pricing consistency has drastically improved across all lodging distribution channels,

with the lowest rates most often found on the branded websites.

• Hotel companies have control over inventory and price. They have cut back on inventory allocation to online travel agents and have driven down merchant markup rates from the high-20% range to the mid- to high-teens range (18%).

• Branded websites are taking the lion’s share of online hotel bookings and online travel agents are feeling the pinch.

• Online travel agent bookings (Expedia, Travelocity, etc.) are highly restrictive with numerous hidden fees. In addition, the perceived deceptive online travel agent practice of paying for placement may be lessening consumer confidence that these are pure shopping experiences giving great value.

• There are benefits to booking through the branded hotel companies’ controlled distribution channels relative to booking through online travel agents, such as higher-quality inventory, guaranteed low rates, and frequent guest point accumulation.

• The shift of hotel bookings toward the branded websites is leading to higher net revenues, higher margins, and increases in profitability.

• Hotel revenues are being maximized through the Internet, given the hotel companies’ abilities to upsell their room products and packaging hotel stays with experiential add-ons (spas, golf, etc.).

• New Internet enhancements (greater booking capabilities, new languages) should lead to greater usage over time.

Please see our research note “Hotels have neutralized Internet threat- next concern for online agents is metasearch” dated January 25, 2006, for our full lodging Internet analysis.



Pricing remains uniform across various distribution channels Price consistency is critical for hotels, not only for profitability but also to ensure consumer confidence. In our 2005 proprietary pricing survey, we checked room rates for standard rooms in five different hotels in each of five cities using seven different distribution channels (1-800 number, company’s own website, Expedia, Hotels.com, Orbitz, Travelocity, and TravelWeb). We checked hotels across the major lodging brands of Fairmont, Four Seasons, Marriott, Starwood, and Hilton.

The average price discrepancy in our September and October 2005 surveys was just $7.99. The variance in price implied a savings of just 2.4% (see Exhibits 23 and 24). Prices were uniform (within $0.50) across the brand’s distribution channels 70% of the time. In most cases where the prices were not consistent across all seven distribution channels, it was the online travel agent sites that had the higher price.

Exhibit 23: All trials 2005 In trial 2005, consumers could have only saved 2.4% on average shopping around

Exhibit 24: All trials 2000 In 2000, consumers could have saved 19.4% on average shopping around

Four Seasons 1.0%Starwood 2.4%Marriott 2.5%Fairmont 2.8%Hilton 3.1%

average 2.4%

Discrepancy (savings) as a %

Marriott 7.0%Four Seasons 11.6%Starwood 29.1%Hilton 29.8%

average 19.4%

Discrepancy (savings) as a %

Source: Goldman Sachs Research. Source: Goldman Sachs Research.

Lowest rates are most often found on branded controlled channels We also found that the lowest rates are most often found on the brand’s controlled distribution channels (1-800 number, website). We found that our hotel company websites carried the lowest available rates 96% of the time when the room was available compared with 86% of the time for the online travel agents (see Exhibit 25). Out of 70 trials when a room was available, the hotels were only undercut six times or just 4% of the time.



Exhibit 25: Lowest rate performance for all distribution channels

Distribution Channel

Reservation Line 52 59 88%Hotel Website 66 69 96%

Expedia 44 48 92%Hotels.com 42 47 89%Orbitz 21 27 78%Travelocity 55 60 92%Travelweb 34 45 76%Third Party Total 196 227 86%

% Lowest Rate

# Times Lowest Rate

# Times Available


Rate consistency takes low-price advantage away from online travel agents The reason that consistency and the fact that the lowest rates are found on the brand’s controlled sites matters is that once consumers realize they can get the same price no matter where they shop, the perceived low-price advantage of booking through an online travel agent will likely disappear, in our opinion. This will allow our hotel companies to increase net revenues, improve margins, and enhance profitability, as consumers who would have otherwise shopped on the online travel agents move to the branded hotel sites, where booking costs are the lowest.

This is a critical point for our hotel companies as they stand to pocket an additional $17 on a $100 room night when a hotel booking moves from an online travel agent site to the branded site. We estimate that a hotel booking made through Hilton.com costs roughly $0.50 on average. The net revenue to Hilton on a $100 hotel rate is $99.50 when booked through Hilton.com. This same booking through an online travel agent such as Expedia or Travelocity results in a profit of just $82.50 for Hilton (see Exhibit 26).

The online travel agent receives an 18% markup fee for selling the Hilton room and there is an additional booking cost via the online travel agent channel ($2.50), leaving less net revenues in the hotel owners’ pockets. It is clear to see that the booking method used can have a significant impact on our hotel companies’ bottom lines. As consumers shift from the online travel agents back to the branded websites, the hotel companies will pocket significantly more revenues, which will lead to higher margins and higher profitability on the same hotel booking.

The opportunity to yield manage without the headache of having an Internet travel agent undercut your own pricing makes for a more robust pricing policy, which we think in turn leads to higher rates for our hotel companies.

Consumers still expect value via the online travel agents, but are beginning to see that the real value lies with the branded hotel websites.



Exhibit 26: Incremental savings for the hotel owner if a consumer shifts booking from online travel agent to branded website

$17.25/ $100 room

•Cost to book through branded Web site •Cost to book through online travel agents

$0.50/ booking 18% markup: $15.25$2.50 fee for CRS connection

Standard $100 room




Hotel companies have control over inventory and price Hotel companies now have control over inventory and price. They have cut back on inventory allocation to online travel agents and have driven down merchant markup rates from the high-20% range to the mid- to high-teens range (18%). In our most recent pricing survey, the online travel agents failed to provide the room we were looking for 35% of the time. Our hotel companies lacked inventory in just 1% of the trials (see Exhibit 27). We think the online travel agents’ lack of branded inventory reflects poorly on them, as these distributors are expected to add value by offering a wider selection of branded and independent inventory.

Exhibit 27: All four pricing trials—missed opportunities to sell rooms

Distribution Channel

Reservation Line 59 70 16%Hotel Website 69 70 1%

Expedia 48 70 31%Hotels.com 47 70 33%Orbitz 27 70 61%Travelocity 60 70 14%Travelweb 45 70 36%Third Party Total 227 350 35%

# Times Available

# of Possibilities % Misses


Hotel inventory is now easily yieldable Hotels now have full control over their inventory and have the ability to turn “on” or “off” the online travel agent’s abilities to sell hotel rooms. Hilton and Marriott all admit to shutting down the online travel agents inventory when they believe they can yield manage higher rates through their own channels.

This is much different than in the past, when hotel rooms were allocated to online travel agents at a wholesale rate. Once these rooms were allocated, our hotel companies could not get these rooms back to sell, which in many instances resulted in “lost opportunity” for our hotel companies when last-minute rates could have been raised. The hotel companies now have a system that they can yield manage much more effectively.

When hotel demand is low and the hotels need to rid themselves of lower-rated or even distressed inventory they can turn on the online travel agent distribution channel. When demand is high, the hotel companies can turn off this distribution outlet. The hotel companies now see the online travel agent distribution channel as one of many options in its overall yield management system.

It is interesting to note that Starwood has commented that it thinks there is a natural yield occurring in the online travel agent arena. It believes that as its hotel prices have risen, the prices have exceeded the budgets of the typical online travel agent customer (i.e., Expedia). In theory, the only rooms that meet the needs of the more price-sensitive online

“Total Available” includes all trials when at least one of the distribution channels had the room in its inventory—all sold-out nights are excluded.

Online travel agents sell a small percentage of hotel rooms for the branded hotel chains, garnering just 1%-2% of hotel bookings on average.

There may be a natural yield occurring in the online travel agent arena as hotel prices have risen.



travel agent shoppers are lower-priced independent hotels or lower-end brands. In essence, Starwood believes that it may be pricing itself out of the online travel agent distribution channel, which targets price-conscious consumers.

Merchant model deals are more favorable As the online travel agents have jockeyed for position with the branded hotel companies, we have seen an evolution toward more supplier-friendly interactions. As the online travel agents have found themselves competing with each other for access to inventory from the hotel operators, the hotels have benefited from lower markup rates. We have seen the average markup rate on merchant sales go from the 25%-30% range two years ago to just 18% now.

This is important because the days of grandiose margins for the online agents of over 30% are now over. As we discussed above, in the past a branded chain would allocate a certain number of hotel rooms to Expedia at a wholesale price. Expedia would then mark up this rate as much as 20% to 30% before selling the room to a consumer. No matter what Expedia sold the room for, the branded hotel would receive only the pre-negotiated wholesale price. If hotel rooms were selling out quickly, Expedia would raise prices and increase its margins, but the hotel would miss out on the upside potential.

This is no longer happening as set markup fees are now negotiated at the corporate level. As an example, if Expedia sells a Hilton room a month in advance for $200 it will receive roughly $30 for booking this sale (18% markup). If, a month later, Hilton has the ability to raise rates on the last rooms available to $300, Hilton will capture the majority of the upside. Expedia will receive a total of $45 (18% markup) for the sale, an additional $15 for the raise in rate. The remaining $85 upside will go to Hilton. In the past, Expedia would have booked the entire upside of $100 instead of Hilton. As these merchant model markups have been uniformly set across all hotels at the corporate level, it is clear to see the hard dollars that our hotel companies have taken back.

Merchant markup rates of 18% are significantly better than the 25%-30% rates just a few years ago.



Branded websites are taking the lion's share of online hotel bookings and online travel agents are feeling the pinch

Consumer acceptance of online bookings is growing and the hotel companies are getting the lion’s share of the action, with at least 80% of their total online bookings via their branded controlled websites. Currently Marriott estimates that its website garners 85% of its online bookings, Starwood 79% and Hilton 85%.

There are disadvantages to booking with online travel agents

Online travel agent bookings can be a hassle It is becoming more apparent that hotel bookings made through online travel agents are a hassle relative to hotel bookings made through the brand’s controlled distribution channels. In fact, many of the bookings made through the online travel agents are highly restrictive, with higher fees—we found a $3.11 additional fee on a booking through Travelocity versus the same booking through Marriott.com and an immediate charge to the credit card (see Exhibit 28). In addition, with pay-for-placement incentives for the online agents, consumers are not necessarily getting a straightforward listing of rooms. We think consumers are wising up to the disadvantages of booking outside the branded controlled distribution channels. The online travel agents are a good place to look to compare rates across brands, but are not necessarily the best place to book branded hotel rooms anymore.

Exhibit 28: Consumers have more to gain booking through the hotel companies’ controlled distribution channels

Type of Booking

Service FeeLoyalty Points

AwardedCredit card processed

Directly with Hotel

No YesDuring your

stay

Through online travel agent

$3.11 NoImmediately

after you book room

Hotel booking fees are based on rates for a standard room at the Orlando

Airport Marriott found on marriott.com and travelocity.com


As an example of the impact of these disadvantages, we compared the total costs for booking a Marriott room on the Marriott.com website versus Travelocity. We found that the cost to book through Marriott.com for a one night stay at the Orlando Airport Marriott was $132.68 (includes $13.68 in tax). We are assuming that we make this booking three months in advance and that our credit card is not charged until we actually stay in the hotel. If we assume a 4% savings rate on the total cost we can subtract $1.31 from our total purchase price, resulting in out-of-pocket expense of $131.37 for booking through Marriott.com.

With the lowest rates now found on the branded websites, with few discrepancies, we believe that the “value” of shopping on the online travel agent sites has drastically diminished.



If we assume that we book three months in advance through Travelocity, our credit card will be immediately charged and we will have to bear additional fees. The original cost for booking this $119 room is $135.79 ($13.68 in taxes, $3.11 in service fees). If we further assume that the consumer is like many Americans with an outstanding balance on their credit card, the fact that this booking is charged upon booking not actual hotel stay results in an additional $4.52 (13.99% interest charge on American Express credit card balances compounded for three months) to the consumer. The total cost for booking through Travelocity if consumers have outstanding balances is as high as $140.31, roughly 6.8% higher than booking through Marriott.com (see Exhibit 29).

Exhibit 29: Consumers have more to gain booking through the hotel companies’ controlled distribution channels

Type of Booking

Standard Room

TaxesService

Fee

Accrued Credit Card Interest

(13.99%)

Accrued Savings Interest (4%)

Total Cost

Directly with Hotel

$119.00 $13.68 $0.00 $0.00 ($1.31) $131.37

Through online travel

agent (1)$119.00 $13.68 $3.11 $4.52 $0.00 $140.31

Hotel booking fees are based on rates for a standard room at the Orlando Airport Marriott found on marriott.com

and travelocity.com. Interest charges and income were calculated over a three month period.


Online agents do not necessarily show the hotel rooms that are the best for their consumers It is interesting to point out that some hotels “pay for placement” on the online travel agent sites. This is becoming a hotly debated issue and one that we think could hurt the online travel agents as consumers wise up to this confusing practice.

Hotels are either paying up-front advertising fees or adjusting margins on a tiered-structure based on where their hotels are being placed. In essence, hotels are paying higher margins on hotel bookings through the online travel agents if the online agents give them top billing on their webpages.

As an example, assume that Expedia has two different branded hotel rooms to sell (Room A and Room B), each being offered for $200. The owner of Room A pays a set 18% markup and does not pay for placement. Expedia will book $30 on the sale (18% markup). In order to receive more prominent display on Expedia, the owner of Room B has agreed to a 22% margin if its hotel room is the first to be displayed or is targeted as an Expedia special. If Expedia sells this room for $200 it will receive $36 in revenue, roughly 20% more than the revenue from booking Room A.

Online travel agents are now starting to maximize revenue by showing the higher-margin hotel rooms, not necessarily the ones that are best for their consumers. With this new practice, the selection of hotels may become limited on the online travel

Paying for placement on online travel agent sites is becoming a hotly debated issue in travel.



agent sites. As consumers wise up to this practice, we believe they may be more inclined to shop the branded websites instead.

There are benefits to booking through the branded hotel companies' controlled distribution channels

Over the past two years, the hotel companies have clearly laid out the advantages to booking through their controlled distribution channels. Hotel bookings through a branded website or 1-800 number have less restrictions, frequent guest points can be earned, and consumers are “guaranteed the lowest rates available.” In addition, the hotel companies have clearly advertised “Web only” and “Net direct rates” and packages that are not available through online travel agents. Not to mention the fact that the online travel agents, in many cases, are only allocated the less desirable and lower-rated rooms by the hotel companies.

The shift of hotel bookings toward the branded websites is leading to higher net revenues, higher margins, and higher profitability

There is no doubt that as more and more hotel bookings are being shifted online the hotels are making more money on each sale. As we discussed above, online travel agent bookings cost hotels at least 18% more on a standard room booking than a booking directly through the branded website. With that said, online travel agents are just a small piece of the distribution pie, selling just 2% of our hotel companies’ total room nights on average. The real costs saves will result from a continued shift of bookings away from the traditional offline travel agents, calls to the 1-800 number, and calls direct to the hotels toward the branded websites (see Exhibit 30).

Exhibit 30: Hotel distribution mix average for the major hotel companies

Direct to hotel51%

Off-line travel agent15%

Online travel agent2%

Branded website12%

1-800 number20%


We believe online agents may be evolving into search engines for users who look, but now choose to book through the branded websites.

Most consumers book rooms by calling the hotel directly.



According to our analysis in 2000, a traditional booking via an offline travel agent costs as much as $16.86 on a standard rate of $100. Offline travel agents receive roughly 10% commissions on the sales ($10) and the cost for the actual booking is roughly $6.86 ($4.00 GDS fee, $0.36 switch fee, $2.50 central reservation system, or CRS, fee). Calls made directly to the hotel or through the company 1-800 number cost roughly $2.00-$2.50 per booking. It is clear to see that the hotels stand to gain at least $2.00 per booking every time a consumer shifts online. When a consumer shifts its bookings away from the third-party online and offline travel agents the savings are even more significant, given the elimination of the commissions to offline agents (10%) and markups (18%) to online agents. The end result is more money in the pockets of our hotel companies for the same $100 booking. We think this is already leading to higher net revenues, higher margins, and increases in profitability at the hotel level.

Hotel revenues are being maximized through the Internet given greater upselling potential

Perhaps one of the most exciting benefits of the Internet is the increased revenues hotels are seeing from an increase in upselling. The information-rich websites, with their detailed amenity listings and pictures, are making it easier for consumers to upgrade to higher-rated rooms. Initially, consumers check rates for standard rooms. In the past, we think consumers were less willing to upgrade as they did not fully understand what they were getting for the incremental spend. We think the “fancy” pictures and the fact that consumers can clearly see what they are paying additional money for (oceanfront room, suite product) helps consumers to justify paying a higher price.

The lodging managements are confirming this trend as upselling has increased on their branded websites. In addition, hotel companies are benefiting from incremental spend on “experiential” purchases. The hotels have significantly built out their websites to include elaborate packages with spa treatments, golf, and restaurant bookings, etc. The ability to package these items together is leading to higher spend per customer.

New Internet enhancements should continue to drive profitability Hotels are continually building out their booking capabilities and enhancing their Internet product. Current initiatives around improving the convention and group meeting sites should lead to significant cost saves over time. Other initiatives to enhance the frequent guest program redemption capabilities online, to ease the booking process through less clicks to confirmation, to enhance packaging products with air and travel providers, and to enhance global distribution through the rollout of websites in a variety of languages should all contribute to an increase in hotel profitability.

The majority of our hotel companies agree that online bookings could grow to as high as 25% of total bookings over time.



*New* Meta-search: the next frontier for lodging distribution over the Internet

We believe that meta-search engines such as Kayak.com and Sidestep.com represent the next frontier for lodging distribution over the Internet. These online travel aggregators scour multiple online travel sites and produce comprehensive lists of the cheapest rates. The consumer can then choose which price looks good and be directed directly to that company’s website. Although these online aggregators currently represent a small portion of the market, the potential business opportunity for our branded hotel companies is real as these aggregators are shifting more and more consumers toward the hotel companies’ lowest distribution channel for a minimal fee.

What do metasearch engines do and how do they make money? Meta-search sites offer an efficient one-stop shop for consumers and enable one comprehensive search versus multiple, time-consuming searches of various vendors. Currently, a handful of aggregators like Sidestep, Kayak, FareChase, Mobissimo, and Qixo are offering their services in the marketplace.

To get sense for how an aggregator works we provide the following example. If a consumer uses a site like Sidestep and searches for hotels in New Orleans, Sidestep will search supplier sites like Marriott.com and Hilton.com as well as online travel agents like Orbitz. Sidestep provides a comprehensive list and enables a customer to filter the hotels by location, amenities, and price range. When the customer clicks on a hotel, he is sent directly to the supplier’s website to book the room.

These “Google-like” travel aggregators do not charge consumers anything and often generate revenue in two ways: flat fees or commissions paid by the suppliers. If an aggregator has a flat fee agreement with a supplier, they will receive a negotiated dollar amount every time a consumer uses their search capability and then books direct on the supplier site.

Commission agreements work in a similar way although the meta-search vendor will be paid a certain percentage of the ticket price rather than a flat fee. In addition to providing comprehensive searches of Internet travel sites, these meta-search engines earn advertising revenues from their travel vendors and some disseminate weekly travel ideas and offers to its customers via email.

Total booking costs for supplier are much lower via meta-search channel Although the economics may vary by supplier we estimate that on average, a hotel room booking costs a supplier just $1.25-$1.75 via the meta-search channel. Sidestep disclosed that it will generally get a 10% commission for its hotel bookings compared to the high-teens commission rates that online travel agents charge. Aside from the cost benefit for travel suppliers, meta search sites are practical for consumers as they offer a one-stop, comprehensive travel search experience.

For the supplier, we estimate that travel bookings through a meta-search engine are about one-third the cost of travel bookings made through an online travel agent.



Key industry risks

• Economic weakness. All lodging companies are susceptible to a lodging cycle downturn as a result of a slowing economy. Historically when business travel has slowed dramatically, major corporations have cut back on costs and have laid off employees. Occupancies tend to decline, hurting overall room revenues along with food and beverage and conference revenues.

• Imbalances in supply and demand. As the supply rate increases and surpasses the rate of demand, earnings are at increased risk. Increased supply growth also implies increased competition. Overbuilding in this sector is extremely difficult to overcome.

• Brand deterioration. Consistency is the most important factor for brand recognition. If consistency falters, brand name is tainted. This is an ongoing risk for management and franchise companies as they market their brands but sometimes do not have a say as to capital expenditures at the property level. Most of the major operators, however, have protected the integrity of their brands through their management contracts. Currently, many management contracts require hotel owners to put a percentage of annual hotel revenues back into the property for normal maintenance expenditures.

• Location and lack of geographic diversification. Urban hotels and big convention hotels are affected more during a downturn than suburban locations.

• Highly leveraged. Hotel companies are now reasonably leveraged, with net debt to total capitalization under 20% for the majority of our lodging companies (excludes REITs). Hilton’s debt level is currently the only one of our companies of concern as they just levered up to purchase Hilton International and currently have a debt balance in the $8 billion range.

• Rising gas and oil prices. Rising gas and oil prices are always a concern especially considering the current geopolitical environment. Hotels have the option of adding “energy surcharges” to their rooms, although we view this option as a last resort. As gasoline prices increase, we believe the reduction in disposable income will affect the lower-priced hotels brands such as Cendant’s Days Inn, Knights Inn, and Howard Johnson brands.

• Increased insurance premiums including terrorism protection. In the past, we would have expected insurance premiums to rise just with inflation, however it has turned out to be much more expensive given geopolitical uncertainty and heightened fear of terrorism in our home market. These higher insurance premiums have significantly affected the bottom lines over the past few years.



Lodging consumer characteristics

Typical lodging customer According to the American Hotel and Lodging Association, customers travel for business roughly 50% of the time and for leisure purposes the other 50% of the time. For business, the customer is either a transient traveler attending an individual or small group meeting or a traveler attending a conference/group meeting. The leisure customer is either traveling on vacation or traveling for personal, family, or other special event reasons (see Exhibit 31).

Exhibit 31: Transient business travelers compose greatest share of lodging customers lodging customer type, 2004

Leisure26%

Conference/group24%

Other 23% Transient business

27%

Source: D.K. Shifflet & Associates Ltd.

Business traveler characteristics According to the American Hotel and Lodging Association, the typical business traveler is male (67%), age 35-54 (52%), employed in a managerial or professional position (50%), and earns an annual income of $81,100. These business travelers make reservations 89% of the time and pay an average $96 per room night. About 39% spend one night, 24% spend two nights, and 37% spend more than two nights.

Leisure traveler characteristics According to the American Hotel and Lodging Association, the typical leisure traveler is aged 35-54 (45%), and earns an annual $72,600. They typically travel by auto (74%), make reservations (90%), and pay an average $89 per room night. Roughly 45% of leisure travelers spend one night, 28% spend two nights, and 27% spend over two nights.

The business traveler is heavily tied to the economy and corporate travel budgets.

For the high-end hotels, business travelers typically comprise over 70% of bookings.



61 Analysis of industry competitors

65 A closer look at lodging REITs

69 Top ten brand franchise characteristics

71 What to ask company management

Th

e players



Analysis of industry competitors

We fundamentally believe that hotel companies are branded consumer service companies. Increasing distribution points is critical to long-term success, as it leads to more brand awareness and brand leverage opportunities. This creates value over a larger base of hotels. We value solid unit growth and expansion potential as dominant drivers for long-term EPS growth.

Strength of business model: we favor management-oriented structure We evaluate the strength of the business model based on whether a company owns and operates, manages, or franchises its hotel products. We typically view management-oriented and franchise-oriented companies more favorably than ownership companies as a result of less capital risk, greater unit growth potential, and greater brand distribution potential (see Exhibit 32). As has been seen in this last downturn, management companies are shielded somewhat from the negative operating leverage of the hotel business. They receive a percentage of the top-line revenues and are not subject to losses at the hotel level.

Exhibit 32: Lodging operator segmentation, excludes REITs

Ownership focused operators- (majority of EBITDA from owned hotels)Orient Express Hotels No unified brand- hotels include the Cipriani, Lapa Palace, Copacabana Palace, Reid's Palace 67% EBITDA from owned hotels, 33% EBITDA from management/partially owned hotels, restaurants, train lines and real estate development

Management and franchise focused operators (majority of EBITDA from management/franchise contracts)Cendant Corp. Franchised brands include Wyndham, Days Inn, Ramada, Super 8, Howard Johnson, Travelodge, Knights Inn, Wingate, AmeriHostFour Seasons Brands include Four Seasons, Regent

more than 90% of operating income from managed hotels with the residual operating income from timeshare/owned operationsMarriott International Brands include Marriott Hotels & Resorts, Renaissance, Courtyard, Residence Inn, Fairfield Inn, TownePlace Suites, Spring Hill Suites 70% operating income from managed/franchised hotels, 30% operating income from timeshare and owned operations

Companies shifting to a more fee-based modelStarwood Hotels & Resorts Brands include Sheraton, Westin, W Hotel, St. Regis/Luxury Collection, Four Points, W Aloft, Le Meridien 35% EBITDA from owned hotels, 38% from management/franchise fees and 27% from timeshare/other operationsHilton Hotels Corp. Brands include Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Homewood Suites, Hampton Inn, Conrad, Scandic59% EBITDA from owned/leased hotels, 33% EBITDA from management/franchise fees and 8% from timeshare operations


Quality of assets and consistency of brands We also highly value the quality of assets and consistency of hotel brands. As a result, we typically value world-renowned unique assets located in high-barrier-to-entry markets quite highly, and we favor those brands with consistent themes, service levels, and high quality.



Unit growth and expansion drive EPS The lodging sector is a relatively mature business with relatively high operating margins. Given this, new unit growth is the key to driving EPS. We believe that management companies are best positioned for new unit development given their less capital-intensive nature and the fact that only 23% of the hotels in Europe currently have an affiliated brand. Management companies are viewed as being less capital intensive, with generally no more than a 20% interest (loans and or equity) in the properties that they manage. The end result is less upfront contribution to each additional unit. As the US-based management companies build brand recognition, we expect to see greater international exposure through new contracts and conversions.

We favor Marriott and Starwood As a result of the above metrics, we place Marriott, Starwood, Four Seasons, Hilton and Orient Express in the upper quadrant of our evaluation matrix based on their high-quality brands and solid unit growth potential. We have historically favored Four Seasons and Marriott given their sound management-oriented business models. With Starwood’s and Hilton’s proposed move toward more fee based revenues we now value them highly in the upper quadrant as well (see Exhibit 33). We believe that companies in this upper quadrant have the highest potential to outperform over the long term. Orient Express is also highly valued given its niche focus, solid unit growth potential, and high-quality assets.

Exhibit 33: Starwood, Marriott, Four Seasons, Hilton and Orient Express are in the upper quadrant evaluation of lodging companies

Un

it G

row

th/

Exp

ansi

onPo

ten

tial

Quality of assets / strength of brand

InterState Hotels& Resorts

Stro

ng

Wea

k

Weak Strong

Four Seasons

Highest potential for outperformance

Least potential for outperformance

Orient Express

Starwood Hotels

Hilton Hotels

Host Hotels & Resorts

Marriott

Strategic Hotels &Resorts


International expansion should drive earnings growth over the next five to ten years.



A historical perspective Although it is nearly impossible to determine just when this $123-billion industry began, we are sure it can be tracked back to biblical times. It most likely began on the barter exchange system with an innkeeper or even individual homeowner providing a safe place to sleep in exchange for food or other services. Either way, lodging has been around a very long time.

Prior to the 1980s, most hoteliers were primarily real estate owners We begin our review of the industry prior to the 1980s, when hotel companies were primarily hotel real estate owners. Occupancy levels were high, and room rates exceeded inflation, which fueled increased building, with debt from an aggressive savings and loan (S&L) industry, and equity from tax-free limited partnerships.

The slowing economy in the mid-1980s revealed the high negative operating leverage of direct ownership (slowing top-line revenues on a relatively high fixed expense structure) making it desirable to reduce real estate exposure. Companies began to reduce their real estate exposure by splitting their companies or selling their real estate interests.

In the late 1980s and early 1990s, limited capital and decline in demand By the late 1980s and into the early 1990s, the flow of capital began to slow owing to changes in tax laws and S&L collapses, and demand began to decelerate as a result of the recession. The lack of capital, however, set up a favorable supply/demand imbalance throughout the 1990s.

During this next period, the lodging industry moved from a period of weak operating conditions from 1986 to 1991 owing to overbuilding and economic recession-induced demand growth deceleration, to the next period, the hyper-growth of 1992-1997, when building stopped, demand accelerated as a result of the accelerating equity capital markets, and earnings momentum ramped up.

In 1998, concerns over the economy led to a further tightening of capital. Against minimal supply growth during this period, however, the lodging companies’ fundamentals rallied on the back of a strong economy through mid-2000. Economic woes soon followed with the bursting of the Internet bubble, September 11, the conflict in the Middle East, and even the SARS epidemic, which suppressed demand trends through 2003.

Lodging began a robust recovery in 4Q2003 The lodging companies began their robust recovery in 4Q2003 as hotel demand came roaring back with a surge in business travel. Higher healthcare, benefits, property tax, and worker’s compensation expense, however, continued to pressure margins, resulting in lackluster operating leverage until late 2004. Thus far in 2006, we have seen continued lodging outperformance, with RevPAR up in the mid- to high single digits year to date and expectations for low-double-digit growth throughout all of 2006. In addition, margin expansion is maintaining momentum with margin expansion expectations of at least 150-200 bp on average for our major lodging operators in 2006 (see Exhibit 34 for an outline of the lodging timeline over the past 20-plus years).

Over-leveraging and high real estate exposure forced many hoteliers into the management structure.

Hoteliers pushed back expansion following 2001, with supply growth decelerating from 3.9% in 1997 to just 1.2% growth in 2003.

Lodging

United S

tates

64 G

oldman S

achs Global Investm

ent Research -

June 2, 2006

Exhibit 34: Lodging timeline

--Hotel companies were managers, franchisers, and real estate owners

--Occupancy levels were high leading to increased building

--Capital into the industry slows

--Recession induced demand deceleration

--Supply starts to stabilize and building in most states comes to a halt.

--Industry experiences hyper-growth

--Building stops, demand accelerates

--Earnings momentum develops

--Real estate downturn sets in

--Hotel companies begin to sell real estate because of negative operating leverage

Late 1980's - Early 1990's

Early-Mid 1980'sPre-1980's Early 1990's - Late 1990's

2000 to 2003

--Industry fundamentals slow with Internet bubble and slowing economy

--September 11 significantly alters travel patterns

--Earnings momentum decelerates as demand lags with increased conflicts in the Middle East and impact of SARS

2004

--Reversal in operating trends

-- Sharp recovery in transient business travel that led to above expectation RevPAR performance

-- Supply growth remained low

2005

--Continued RevPAR improvement with rate driving almost 70% of the upside

--Margin expansion occuring, but companies still significantly below peak levels

2006

--Third year in a row of high single-digit RevPAR growth expectations; rates forecast to drive over 75% of the upside.

--Supply growth continues to come in below expectations

--Margin expansion story in tact as companies still 400-500bps below peak levels

--Private equity interest in hotel assets remains high and the major operators continue shift to a more "asset light" business model

Source: Compiled by Goldman Sachs Research.



A closer look at lodging REITs

In this new section we take a closer look at a growing subsector within the lodging industry, lodging REITs. We detail the qualifications to become a REIT, lay out the competitive landscape, and discuss lodging REIT valuation.

What is a REIT? A Real Estate Investment Trust (REIT) is a company that owns and usually operates income-producing real estate, including office and industrial buildings, malls, shopping centers, multifamily properties, hotels, health care facilities, storage units, and even mortgages. The REIT structure permits companies to deduct dividends paid to investors from its corporate taxable income thereby eliminating the issue of double taxation. Per the National Association of Real Estate Investment Trusts (NAREIT), the key provisions for a company to qualify as a REIT per the tax code include the following:

• It must distribute at least 90% of its taxable income in the form of dividends to investors.

• At least 75% of the total assets must be invested in real estate assets. • At least 75% of the gross income must come from property rents or interest on

mortgages. • No more than 20% of assets consist of stocks in taxable REIT subsidiaries.

The REIT structure provides investors a tax efficient option for investing in real estate and a way to participate in the income stream without owning properties.

Lodging REITs In addition to the qualifications above, Lodging REITs are not permitted to operate the hotels or derive any income from the operations of the hotels. Lodging REITs typically acquire the hotel and pay fees to a third-party manger to operate the property. The REIT Modernization Act of 2002, which permitted the formation of taxable REIT subsidiaries (TRS), still maintains that the TRS may not operate or manage a lodging facility. The TRS may only lease the lodging facility from the REIT at market rates.

Per NAREIT, there are 18 lodging REITs. We estimate an equity market capitalization for the lodging REITs of $23.8 billion, representing approximately 6% of the REIT industry, and an average dividend yield of 4%.

The market for lodging REITs has been strong over the past two years, with five lodging REIT IPOs and numerous secondary offerings throughout 2004, 2005, and 2006. The lodging REIT IPOs raised approximately $1.2 billion of capital, representing 21% of the REIT equity issued via IPOs during this time period (see Exhibit 35).

A REIT can be publicly or privately held.

Per NAREIT, as of May 27, 2005, there were 151 publicly traded equity REITs.



Exhibit 35: Lodging REIT universe we currently cover two lodging REITs: Host Hotels and Resorts, and Strategic Hotels and Resorts

TickerEquity Mkt Cap (mm)

Dividend Yield IPO Date Hotels Rooms Headquarters

Ashford Hospitality Trust AHT 731.6$ 7.4% Aug-03 72 12,266 Dallas, TXBoykin Lodging Company BOY 215.6 0.0% Nov-96 21 5,871 Cleveland, OHEagle Hospitality EHP 212.6 7.7% Oct-04 12 3,200 Covington, KYEquity Inns, Inc. ENN 850.6 5.6% Mar-94 125 14,845 Memphis, TNFelCor Lodging Trust Inc. FCH 1,341.3 2.8% Jul-94 115 33,000 Irving, TXHersha Hospitality HT 269.4 7.8% Jan-99 58 7,211 New Cumberland, PAHighland Hospitality Corporation HIH 724.1 5.3% Dec-03 26 8,200 McLean, VAHospitality Properties Trust HPT 2,977.5 7.1% Aug-95 310 46,000 Newton, MAHost Hotels and Resorts HST 10,706.4 2.8% Dec-98 129 65,000 Bethesda, MDSupertel Hospitality SPPR 69.6 4.1% Nov-94 76 5,361 Norfolk, NEInnkeepers USA Trust KPA 685.2 3.8% Oct-94 70 8,816 Palm Beach, FLLaSalle Hotel Properties LHO 1,612.0 2.9% Apr-98 28 8,400 Bethesda, MDMHI Hospitality Corporation MDH 95.3 7.6% Dec-04 7 1,673 Williamsburg, VAStrategic Hotels and Resorts BEE 1,287.1 4.4% Jun-04 18 8,463 Chicago, ILSunstone Hotel Investors Inc. SHO 1,760.1 4.4% Oct-04 62 18,236 San Clemente, CAWinston Hotels WXH 299.8 5.6% Jun-94 55 7,542 Raleigh, NCTotal/Weighted Average 23,838.2$ 4.0%

Bold indicates companies covered by Goldman Sachs Research

Source: Company data, Goldman Sachs Research estimates, and NAREIT.

Lodging REITs can only manage their assets A lodging REIT is typically a collection of assets with no unifying brand and it is heavily tied to the operating leverage of the hotel business. Lodging REITS make money by buying a hotel and bringing in a third-party manager to run the hotel. For example, Strategic Hotel Capital would partner with Marriott to manage its hotel and after the manager pays all expenses and receives its compensation through base fees and incentive fees, the remainder goes to Strategic Hotel Capital. REITs benefit from RevPAR growth and operating leverage, along with real estate appreciation at the property level. The provisions to qualify as a REIT restrict lodging REITs from management and franchise opportunities, which, we view as two highly profitable growth strategies within the lodging sector.

We prefer lodging C-corps investments over lodging REIT investments We have historically been more bullish toward the C-corp Lodging stocks based on their multi-pronged growth strategies. Over the long term we believe the diversified sources of growth for C-corps will lead to greater and extended returns versus the more narrowly defined, less creative, and lower-margin opportunities available to lodging REITs.

One of the main concerns we have for lodging REITs relative to the C-corps is the REIT’s penchant for growth by acquisition. In general, this leads to a lumpy and less visible earnings stream. In addition, given the current environment of lodging assets trading at record multiples there is a higher risk of overpaying in order to meet the stated growth targets.

A lodging REIT manages the assets and its hotel managers, but not the property operations.



In general, we believe there are more growth opportunities in the C-corp lodging stocks and less downside risks in an economic slowdown as c-corps have additional revenue streams (management, franchise, timeshare) to fall back on. This was evident in the most recent downturn, as Host Hotels and Resorts cut its dividend in 4Q2001 given the significant earnings shortfall following September 11. Hilton, Marriott, and Starwood, however, were able to maintain their dividends throughout this turbulent period.

In the following chart we review the growth strategies for lodging C-corps and lodging REITs.

Exhibit 36: Lodging REITs versus C-corps Lodging C-corps such as Marriott, Starwood, and Hilton have multi-pronged growth strategies

Growth Strategies RevPAR growth

real estate appreciation operating leverage

growth by acquisition organic unit growth

Franchising Management

timeshare initiatives


Valuation comparison for lodging REITs Relative to the lodging C-corps, the lodging REITs are not attractively valued, in our view. Historically, lodging REITs have traded in line to slightly above our lodging C-corps on an EV/EBITDA basis despite the lower growth prospects and lower dividend yields over the past three years. We admit that given our coverage universe, we are restricted from looking at lodging REITs relative to the broader REIT universe, and in fact some investors may look at lodging REITs relative to the overall REIT universe and not within the lodging sector. Within the REIT universe, an argument can be made that the lodging REITs are attractively valued. They currently trade at a 2-point FFO multiple discount and a 3-point EV/EBITDA multiple discount to the average REIT sector (includes industrial/office, retail, residential, healthcare, and self-storage REITs).

We would point out that there is higher risk to lodging REITs given that hotel rooms are “rented” daily and apartment and office REITs can be considered more stable given the longer-term nature of their lease agreements. Nonetheless, when looking at lodging REITs versus the broader REIT sectors, the multiples tend to be toward the lower end of the range.

Net asset value may also be used to value REITs An additional metric used to value lodging REITs is net asset value (NAV). NAV is a value for the company based on where the assets would trade in the sales market. The analysis involves taking the company’s net operating income (less 4% for an FF&E reserve) and dividing it by the appropriate capitalization rate. Capitalization rates are set

Lodging REITs trade at a discount to the broader REIT universe.

Capitalization rates are calculated as net operating income divided by total transaction cost.

Lodging REIT Growth Strategies

Lodging C-Corp Growth Strategies



by the market based on current sales transactions and are a similar metric to EBITDA multiples used for the lodging C-corps. EBITDA multiples are calculated as total transaction cost divided by EBITDA, whereas capitalization rates are calculated as net operating income divided by total transaction cost. Property types tend to trade within a band of capitalization rates over time that are differentiated based on age, market, and quality. Historically, capitalization rates for lodging REITs have been in the 6%-12% range.



Top ten brand franchise characteristics

Below is a review of our framework for judging brand dominance in the hospitality sector. We believe that these “top ten brand franchise characteristics” are crucial for continued outperformance in the lodging sector. The companies that master all these characteristics will inevitably have the strongest lodging company in the end.

1. Pricing flexibility. Strong brands allow for more aggressive pricing, as customers are willing to pay up for the perceived quality of the brand. We believe that Four Seasons and Marriott have the two strongest brands in the lodging market today, which allow them to achieve significant RevPAR premiums in their respective marketplaces.

2. Low-cost producer. The purchasing power, unique product characteristics, or economies of scale make it difficult for competitors to match costs. Marriott, Accor, InterContinental, Hilton Hotels, and Starwood, given their massive size, have the biggest pricing power and can aggressively beat the expense structures of independent hotels.

3. International opportunities. Rapidly expanding economies offer additional growth venues in international markets. The consistency of a brand is often of even greater value in emerging markets, giving Marriott, Four Seasons, and Starwood the leg up. Marriott and Starwood currently have over 25% and 50% of their development pipelines slated for international locations and Hilton’s recent purchase of Hilton International has now opened it up to expand globally.

4. Significant barriers to entry. Product development time and expense, sourcing capabilities, production expertise, or simply customer perceptions protect the market share of branded franchise companies.

5. Low penetration of product. Opportunities for increased market share, particularly outside the home market, afford additional growth paths. Although the US-based lodging companies are fairly well represented in the US, outside the US hotel chains are highly fragmented. In Europe, which is the largest lodging market, only 23% of the market is currently branded. Marriott, Four Seasons, Orient Express, Hilton, and Starwood have already implemented aggressive international expansion programs.

6. Solid balance sheet and strong free cash flow generation. A relatively underleveraged balance sheet and strong cash generation bring financial flexibility including share buybacks, higher dividend payouts, opportunistic acquisitions, and new product capital expenditures. Marriott and Four Seasons really stand out on this characteristic, generating significant free cash flow with relatively low debt levels.

7. Increasing market share. Relative to the competition, branded companies usually build or sustain market share at a higher rate. Our most recent analysis of the US development pipeline shows that Hilton accounts for roughly 16% of the development pipeline with Starwood and Marriott accounting for 10% and 6% respectively (based on number of hotel rooms).

8. Active new product development. New products and the refinement of existing ones are critical to sustaining the growth and vitality of the brand. Marriott, Four



Seasons, Hilton, and Starwood have all expanded into the timeshare sector and are starting to accelerate growth into branded residential apartments/communities. In addition, Starwood is extending its brand reach into Bliss spas and is starting to more aggressively market its hotel room product through the sale of its heavenly bed products.

9. Stable to increasing margins. Great branded companies should improve margins either through pricing flexibility or increased operating leverage, and they tend to show improving returns on capital.

10. Shareholder-oriented management team. Shareholder-oriented management is often achieved through incentive-based compensation or significant stock ownership. We favor companies with a high percentage of inside ownership and those companies that base compensation (including stock option grants) of senior management on meeting earnings goals.



What to ask company management

1. Hotel companies appear to have won control of the Internet distribution channel. What strategic alliances does your company have with third-party online agents now and how do you think this relationship will be different in ten years?

2. Given the strength in leisure travel, the timeshare segment of your operations helped to offset the decline in the core lodging business post the 2001 downturn. Will timeshare continue to contribute 15%-20% revenues or are you looking to expand this business further in the future? What do you attribute the strength in timeshare to over the past three years?

3. What factors will influence the staying power of your family of brands? Are there potential new brands under development?

4. The frequent guests program has to cost somebody more money given the added benefits? Who is losing and where does it show up?

5. What percentage of your properties are truly up to standard? Do you consider your brands consistent across the entire portfolio? As a manager and/or owner, how do you ensure the consistency of your product?

6. What will capital expenditures be over the next few years and how do you measure your returns on investment?

7. Yield management systems seem to be more and more technologically advanced. How much in annual savings do you anticipate over the next several years?

8. Cross-selling your family of brands is critical in an increasingly competitive environment. What is the percentage of cross-selling across your portfolio and how do you measure this?

9. What percentage of your rooms are booked 12, 6, 3, and 1 month in advance?

10. In a highly fragmented Europe and Asia market, how do US-based companies make a mark? What is your plan for international expansion?

11. One of the major drivers of lodging earnings is significant unit growth. What are the capital requirements for expansion internationally? Are you finding that you have to put more upfront capital into the Asian and European markets to get the management deals?

12. What is your rationale for investing in new hotel mezzanine financing and sliver equity? What are your investing parameters for these types of investments? What is your off-balance-sheet exposure and off-balance-sheet guarantees?

13. What has been the trend for independent hotels converting to your family of brands? Do you actively approach independent hotel owners or do the independent hotel owners approach you?

14. How long is the typical management contract for each brand? What is the incentive fee structure for you brands?



15. What portion of cash flow is dedicated to capex, share buybacks, and debt reduction?

16. When evaluating acquisition opportunities, what do you look for in regard to individual properties and whole companies?

17. What is the composition of your customer mix (i.e., business versus leisure, group versus free independent traveler (FIT), United States versus international)?

18. Peak margin performance has historically been in the mid-30% range. How far off peak margin performance are you and realistically when do you think you can achieve peak margins? Will the cost saves via distribution through the Internet help your company surpass peak margins in the future?



74 Valuation and stock selection metrics

79 Key earnings drivers

80 Economic and demand indicators

81 Analyzing lodging performance

Th

e nu

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Valuation and stock selection metrics

Key valuation metrics--EV/EBITDA and P/E ratios • Enterprise-Value-to-EBITDA (EV/EBITDA) ratio is the primary metric for valuing

lodging companies. Our primary metric to value lodging companies is enterprise value-to-earnings before interest, taxes, depreciation, and amortization. The EV/EBITDA ratio makes global comparisons easier as it accounts for the effects of differing capital structures and ignores non-cash depreciation and amortization expenses, which run high for lodging companies.

On an EV/EBITDA basis, hotel management companies (i.e., Four Seasons and Marriott) have historically traded at a premium to more traditional hotel ownership companies (Hilton and Starwood). Besides strong brands and management teams at Four Seasons and Marriott we also point out that another driver of the valuation disparity is quality of their balance sheets. We point out that Starwood and Hilton also manage hotels, but the majority of their profits still come from hotel ownership operations. As they potentially evolve toward more management companies with less leverage to ownership, we would expect them to close this valuation gap.

The more niche-focused Orient Express (specializes in world renowned luxury hotels) typically trades between the hotel management companies and hotel ownership companies.

• Price-to-earnings (P/E) ratio used less often. We also use absolute and relative price-to-earnings (P/E) ratios to value lodging stocks. The average forward P/E multiple of Goldman Sachs Lodging Index (GSLI) from January 1988 to April 2006 has been 20 times forward earnings estimates (see Exhibits 37-38).

Exhibit 37: Goldman Sachs Lodging Index (GSLI) valuation, January 1988-April 2006 absolute P/E performance to S&P 500

5 x

10 x

15 x

20 x

25 x

30 x

35 x

40 x

45 x

50 x

55 x

Jan

-88

Au

g-8

8

Mar

-89

Oct

-89

May

-90

Dec

-90

Jul-

91

Feb

-92

Sep

-92

Ap

r-93

No

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-94

Jan

-95

Au

g-9

5

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Dec

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Au

g-0

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-03

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-04

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-04

Jul-

05

Feb

-06

Trailing Forward

Source: Goldman Sachs Research, FactSet.

Marriott typically has traded at a 2-3 point premium to Starwood and Hilton. Four Seasons has typically traded at a significant 10-15 point premium to all lodging operators.



Exhibit 38: Goldman Sachs Lodging Index (GSLI) valuation, January 1988-April 2006 relative P/E performance to S&P 500

25 %

75 %

125 %

175 %

225 %

275 %

Jan

-88

Au

g-8

8

Mar

-89

Oct

-89

May

-90

Dec

-90

Jul-

91

Feb

-92

Sep

-92

Ap

r-93

No

v-93

Jun

-94

Jan

-95

Au

g-9

5

Mar

-96

Oct

-96

May

-97

Dec

-97

Jul-

98

Feb

-99

Sep

-99

Ap

r-00

No

v-00

Jun

-01

Jan

-02

Au

g-0

2

Mar

-03

Oct

-03

May

-04

Dec

-04

Jul-

05

Feb

-06

Trailing Forward


What drives lodging stocks? We do not believe that valuation in and of itself should be the ultimate driver of investment recommendation. Instead sustainability of earnings growth should be the main driver for lodging performance. We ultimately believe that hotel stocks trade as a group based on sector supply/demand dynamics, but the companies with the strongest brand and development opportunities lead the group.

Investors will pay the most for top-line growth, giving the greatest value to same-store or RevPAR growth (revenue per available room), followed closely by unit growth. Margin expansion initiatives are also highly valued, followed by growth by acquisition, share buyback, and debt paydown, in that order (see Exhibit 39).



Exhibit 39: What investors pay for

Acquisitions

Margin Expansion(cost cuts and operating leverage)

Organic Growth (unit growth and RevPAR)

Debt Paydown/ Share Repurchase

Inve

stor

Cre

dit

for

Gro

wth

Source: Company data, Goldman Sachs Research.

Historical price performance analysis Lodging shares are typically viewed as growth stocks given their high unit growth and brand expansion potential. With that said, lodging stocks do have a cyclical component as shares react to the rise and fall of the economy.

Looking at the past 18 years of hotel data and the performance of our Goldman Sachs Lodging Index (GSLI), we have found that lodging stocks will perform in accordance with the spread between supply and demand growth. Over the past 18 years, demand growth has outpaced supply growth ten times (see Exhibits 40-42). In all of these instances, the GSLI showed positive performance.



Exhibit 40: Demand minus supply growth basis point difference

(600)

(500)

(400)

(300)

(200)

(100)

0

100

200

300

400

500

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Source: Smith Travel Research.

Exhibit 41: GSLI annual percentage change

-80 %

-60 %

-40 %

-20 %

0 %

20 %

40 %

60 %

80 %

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Source: Goldman Sachs Research estimates.

Demand growth has outpaced supply growth 10 times over the past 18 years.

The GSLI showed positive performance ten out of the ten times that demand growth outpaced supply growth.



Exhibit 42: Goldman Sachs Lodging Index, December 1984-April 2006

0

100

200

300

400

500

600

700

800

900

1000D

e c-8

4

Dec

-85

De c

- 86

Dec

-87

De c

- 88

Dec

-89

De c

-90

Dec

-91

De c

-92

De c

-93

Dec

-94

De c

-95

Dec

-96

De c

- 97

Dec

-98

De c

- 99

Dec

-00

De c

-01

De c

-02

Dec

-03

De c

-04

Dec

-05

Ind

ex

Goldman Sachs Lodging Index

S&P 500

S&P 500 reindexed as of December 1984.

MONTH-TO-MONTH PRICE PERFORMANCE % S&P % Relative GSLI Change 500 Change GSLI/S&P 500

Mar-05Apr-05May-05Jun-05Jul-05Aug-05Sept-05Oct-05Nov-05Dec-05Jan-06Feb-06Mar-06Apr-06YTD

118111571192119112341220122912071249124812801281129513111311

3.4-4.86.82.23.3

-7.0-0.8-3.88.85.81.31.14.70.48.0

570543580592612569564543591625633642672675675

-1.9-2.03.00.03.6

-1.10.7

-1.83.5

-0.12.50.01.11.25.0

675

5.3-2.83.82.2

-0.3-5.9-1.5-2.05.35.9

-1.21.03.6

-0.83.0

784




Key earnings drivers

The key earnings drivers for lodging include unit growth, international brand extension and expansion opportunities, and supply/demand relationships. Also enhancing growth are same-store sales metrics such as increases in average daily rates and occupancy.

• Unit growth. New unit development is the ultimate driver of earnings.

• International brand extension and expansion opportunities. With only 23% of the European lodging market branded, there is substantial opportunity for US companies to expand abroad. Also significant brand extension opportunities such as timeshare and residential apartments should continue to make up a larger percentage of overall company revenues.

• Supply/demand relationships. Spread between industry supply and demand growth is closely monitored. Historically, RevPAR growth accelerates when demand growth outpaces supply demand.

• RevPAR growth. Revenue per available room measures the average daily room rate times the average occupancy rate.

• Average room rate. Room rate increases are highly profitable, more so than occupancy gains.

• Room occupancy. Room occupancy levels are a prime determinant of hotel productivity. When occupancy levels are abnormally high, it is important to note that it may mean that rates are too low.

• Effective cash flow deployment. Cash flow from operations that is used for low internal rate of return (IRR) projects such as maintenance and gimmick programs ultimately lower earnings. Additional property-level amenities such as spas and workout facilities, however, add to earnings.

• Degree of operating leverage. Higher levels of operating leverage exacerbate the effect of a slowdown on operating profits given slowing top-line revenues on a relatively high-fixed expense structure. However, in robust times the high operating leverage accelerates profits as revenues increase and costs remain relatively fixed.

• Favorable labor costs. Labor is currently the highest expense for hoteliers. The recent rise in unemployment should ease wage pressures and reduce turnover over the next several months.

• Balance sheet leverage. Lodging companies are generally highly levered. Changes in interest rates can have a significant impact to EPS to the upside and downside.



Economic and demand indicators

• Gross domestic product (GDP). Lodging is an economically sensitive sector, with lodging demand correlated to GDP. Historically, lodging demand has lagged GDP by two quarters.

• Consumer price index (CPI). We compare room rate increases with overall inflation growth to measure pricing trends.

• Supply and demand. Supply and demand comparisons alert us to secular imbalances.

• Convention attendance statistics. Conferences and large conventions have been a significant driver of visitation and mid-week occupancy for the large city-centered hotels. Large convention cities include Las Vegas, New York, Orlando, San Francisco, Chicago, and New Orleans.



Analyzing lodging performance

When analyzing lodging performance, we look at three variables: average daily rate (ADR), occupancy (percentage of rooms rented over total rooms available), and revenue per available room (RevPAR), which is calculated by multiplying ADR times occupancy.

We look at RevPAR to analyze lodging performance RevPAR is calculated by multiplying ADR by occupancy and is widely regarded as the best metric by which to analyze lodging performance. Balancing ADRs and occupancies at the hotel level is difficult. Typically when hotel rates rise, occupancies fall and vice versa. The problem that hoteliers face is in determining the right combination of rate and occupancy to maximize revenues at the property level. Years of hotel data have been compiled and complex yield management systems have been developed to help hotel companies do just that.

Exhibit 43 details how revenues can increase from the $70 per available room level. Hoteliers can achieve a higher $72 per available room by either raising or lowering rates. Depending on hotel demand, the changes in rates will have a varying impact on hotel occupancy. More important to note is the fact that raising hotel rates do not always result in higher revenues. Higher rates may in fact keep on-the-margin consumers at home, resulting in lower occupancies and lower overall revenues.

Exhibit 43: Raising rates does not always result in higher revenues at the property level analysis of changes in occupancy and ADRs on RevPAR

OccupancyAverage daily rate

(ADR) RevPAR

Lower occupancy at various rates 60% $120.00 $72.00

60% $110.00 $66.00

Base occupancy and rate 70% $100.00 $70.00

Higher occupancy at various rates 80% $90.00 $72.00

80% $80.00 $64.00

Achieve same revenue per available room through different strategies.

Source: Goldman Sachs Research estimates.

We look at rates and occupancies individually to analyze hotel profits When analyzing revenue at the property level, we use RevPAR, but when analyzing the impact of these changes on the profit line we look more closely at RevPAR’s components. At the profit level, it does matter how RevPAR increases are achieved. Hoteliers will achieve higher profits through increases in rate rather than increases in occupancies. The reason is that increases in rates are not accompanied by incremental costs. Increases in occupancies, however, are typically accompanied by higher costs, as hotels need people to clean the rooms and to service customers.

RevPAR is widely used as the key lodging metric.

Looking at either occupancy or ADRs individually can be misleading when analyzing the impact on overall revenues.



One way that hotels manage labor expenses is to closely monitor employee hours. When occupancies are low, employee hours and labor expenses are reduced. Faced with slow times, hoteliers have two options to raise revenues: either raise occupancies through lowering rates, or raise rates, thereby lowering occupancies. Raising occupancies is less advantageous as costs rise and margins are squeezed. Raising rates is typically more advantageous at the profit level given the cost saves. The trick for hoteliers is to raise the rates without affecting overall occupancy.

History of RevPAR • Over the past 38 years (1968-2005), RevPAR growth has averaged 6.0% (see Exhibit

44).

Exhibit 44: Annual RevPAR growth has been negative only three times over last 38 years

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

% c

han

ge

Source: PricewaterhouseCoopers (1967-1986; 2001-2002), Smith Travel Research (1987-2005).

In robust economies and in slowing economies, ADRs and occupancies have been known to move in the same direction.



• RevPAR growth is driven by economic conditions, not political or social events. Looking back at the past 70 years of hotel data and taking into consideration major historic events such as Pearl Harbor, Korean War, Cuban Missile Crisis, JFK assassination, energy crisis, Iranian hostage crisis, and Gulf War, we have found that major historic events have had only a temporary (less than six months) impact on lodging performance (see Exhibits 45-51). The bigger impact on lodging performance is the condition of the underlying economy.

Exhibit 45: Effect of Pearl Harbor bombing on RevPAR growth 24 months pre- and post-event % change over prior year

Exhibit 46: Effect of Korean War on RevPAR growth 24 months pre- and post-event % change over prior year

Source: PricewaterhouseCoopers LLP (2001) based on Horwath Hotel Accountant data.


Exhibit 47: Effect of JFK assassination on RevPAR growth 24 months pre- and post-event % change over prior year

Exhibit 48: Effect of Cuban missile crisis on RevPAR growth 24 months pre- and post-event % change over prior year



-5

0

5

10

15

20

25

3024 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24

-5

0

5

10

15

20

25

3024 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24

-10-8-6-4-20

2468

1012

24 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24

-10-8-6-4-20

2468

1012

24 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24

-6

-4

-2

0

2

4

6

8

10

1224 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24

-6

-4

-2

0

2

4

6

8

10

1224 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24

-8

-6

-4

-2

0

2

4

6

8

1024 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24

-8

-6

-4

-2

0

2

4

6

8

1024 21 18 15 12 9 6 3 0 3 6 9 12 15 18 21 24



Exhibit 49: Effect of energy crisis of 1973 on RevPAR growth indexed eight quarters pre- and post event

Exhibit 50: Effect of Gulf War on RevPAR growth indexed eight quarters pre- and post event

Source: PricewaterhouseCoopers LLP, Smith Travel Research. Source: PricewaterhouseCoopers LLP, Smith Travel Research.

60

80

100

1208 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8

60

80

100

1208 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8

60

80

100

1208 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8

60

80

100

1208 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8



A closer look at the 1990-1991 Iraqi conflict

Exhibit 51: Major lodging stocks traded down 40% during 1990-1991 Persian Gulf War but bounced back within a year

7/15/90: Iraq accuses Kuwait of stealing oil and warns of military action.

7/22/90: Iraq begins military buildup against Kuwait.

8/2/90: Iraq invades Kuwait and masses troops along Saudi border.

8/9/90: First U.S. military forces arrive in Saudi Arabia.

12/17/90: U.N. sets deadline for Iraqi withdrawal for 1/15/91.

1/17/91: Operation Desert Storm begins.

1/30/91: First important ground battle.

2/26/91: Iraq withdraws from Kuwait.

2/12/91: Coalition force destroys three major bridges in Baghdad.

0

20

40

60

80

100

120

140

5/1/

90

5/15

/90

5/29

/90

6/12

/90

6/26

/90

7/10

/90

7/24

/90

8/7/

90

8/21

/90

9/4/

90

9/18

/90

10/2

/90

10/1

6/90

10/3

0/90

11/1

3/90

11/2

7/90

12/1

1/90

12/2

5/90

1/8/

91

1/22

/91

2/5/

91

2/19

/91

3/5/

91

3/19

/91

4/2/

91

4/16

/91

4/30

/91

5/14

/91

5/28

/91

La Quinta Corp. Host Marrio tt/Marriott Hilton Hotels Four Seasons (US $) S&P 500



















0

20

40

60

80

100

120

140

5/1/

90

5/15

/90

5/29

/90

6/12

/90

6/26

/90

7/10

/90

7/24

/90

8/7/

90

8/21

/90

9/4/

90

9/18

/90

10/2

/90

10/1

6/90

10/3

0/90

11/1

3/90

11/2

7/90

12/1

1/90

12/2

5/90

1/8/

91

1/22

/91

2/5/

91

2/19

/91

3/5/

91

3/19

/91

4/2/

91

4/16

/91

4/30

/91

5/14

/91

5/28

/91

La Quinta Corp. Host Marrio tt/Marriott Hilton Hotels Four Seasons (US $) S&P 500




88 An inside look at frequent guest programs

92 Appendix I: industry terminology

94 Appendix II: additional sources of information

96 Regional research team

Mo

re resou

rces



An inside look at frequent guest programs

Frequent guest programs have become a very important marketing tool for the lodging companies. These programs yield repeat business by rewarding frequent guests with points, which are accumulated and later put toward future hotel stays, transferred for airline miles, or for other rewards. We believe that these loyalty programs are crucial for longevity in the lodging industry. Without a competing program, companies will quickly lose market share.

In this section, we discuss how these programs are funded and accounted for, and lay out the competitive features and rules for some of the premier frequent guest programs.

How frequent guest programs are funded When hotel points are earned. When a frequent guest member checks into a hotel and pays $250 for a night’s stay, roughly $12.50-$15.00 (5%-6% of nightly room charge) is charged to that individual hotel (see Exhibits 52-53). This hotel is essentially paying a fee on the points earned at its hotel, which will go toward the future redemption value of those points, which will more than likely be redeemed at a different hotel. This money goes into a general cash account at the corporate level.

When points are redeemed. When a frequent guest redeems points at a participating hotel, that hotel receives the cash value of the redemption from the corporate general cash account. Generally the cash value of the redemption is a predetermined amount based on a percentage of the current rack rate (see Exhibit 54).

How hotel companies account for frequent guest programs When hotel companies receive cash (5%-6% of a hotel stay) for frequent guest point accumulation, that cash goes directly into the general cash account. Under the new accounting method, revenues are deferred equal to the fair value of the hotel company’s future redemption obligation. The fair value of the future redemption obligation is based on a statistical formula that takes into account the following metrics:

• Projected timing of future point redemption.

• Estimate of the points that will eventually be redeemed.

• Estimate for breakage of points that will never be redeemed.

These factors determine the required liability for outstanding points, which is generally accounted for in the other liabilities section of the balance sheet. We suspect that hotels may be able to change the true liability value by changing the number of points needed for redemption and the number of points needed for a free stay.

Upon the final redemption of points, hotel companies recognize amounts that were previously deferred as revenue. The costs of the reward redemption that the hotel companies have to pay out to the individual hotel is recognized as the expense.



How customers build points Building and acquiring points has become a life-long endeavor for many loyal hotel customers. Most programs credit customers a predetermined amount of points for each dollar spent at a participating hotel. The majority of points are built in this manner, but additional points can be earned through affiliated partner programs. Hotel companies have partnered themselves with credit card companies, car rental companies, airlines, long distance phone services, and even charities. This allows its customers to build hotel points by spending money on a branded VISA card, renting a car, or by flying on a partner airline.

For example, Marriott Reward points can be earned by shopping with a Marriott-branded VISA card, and Starwood preferred guest points can be earned by renting a car from Avis.

How customers redeem points There are a variety of ways that accumulated points can be used. Most points are redeemed for free hotel stays at participating hotels, but points can also be used toward free airline flights, phone cards, car rentals, cruises, and gift certificates from affiliated partners. Points can also be transferred into airline miles or even gifted to charities.

What makes a frequent guest program the best? In our opinion, it is ultimately the hotel companies with the best brands, highest-quality assets, and widest geographic and product distribution that will have the best frequent guest programs in the end. Consumers that participate in these programs do so primarily to build points for future hotel stays in their “hotel of choice.” Additional point-building and redemption capabilities are added benefits but are not the dominant forces behind which programs are most widely used.

With that said, we have laid out some competitive advantages that some programs have along with gimmicks that they have used to lure consumers.

• Greater point building and redemption capabilities. Although many of the frequent guest programs have the same affiliated partners and programs, some have a wider variety of options and less stringent point-building capabilities.

• No blackout dates. One of the major complaints regarding these frequent guests programs is that consumers can never redeem points when they want, given blackout dates. Blackout dates are designated dates around holiday periods, such Labor Day and Memorial Day weekend, in which redemption of reward points is not allowed. Starwood Hotels & Resorts was the first to implement a no-blackout-date policy.

• StayAnytime rewards. Marriott has not excluded blackout dates but does have a StayAnytime reward. For 50% more points, customers can stay at their hotel of choice regardless of any blackout dates or capacity controls at the hotel, as long as there is room available.

• Double-dipping options. Hilton Hotels implemented its Double Dipping program, which allows customers to earn hotel points and airline miles at the same time. Competing programs make customers choose between earnings hotel points and earning airline miles.

Lodging points can be accumulated in a variety of ways.



Exhibit 52: How frequent guest program works—step one


Exhibit 53: How frequent guest program works—step two


Example assumes that hotel corporation (program manager) is a company such as Marriott, Hilton, or Starwood. The hotel is independently owned by an outside party.

Frequent guest pays $250 in room revenue at a Dallas property and earns 2,500 reward points.

Hotel owner pays 5%-6% of room revenue to hotel corporation (Program manager).

$250 to hotel 2,500

reward points

$12.50 to $15.00

Hotel Corporation (Program Manager) Balance sheet: A. General Cash Account increases by $12.50 to $15.00.

Cash is divided into two parts.1. A small part of the cash is used to pay

for the operating expenses of the frequent guest program.

2. Remainder of cash is booked as deferred revenue.

B. Deferred revenue is the liability account: Amount equals the fair value of future redemption obligation.

Future redemption obligation dependent upon:1. Projected timing of future point redemption2. Estimate of points that will be redeemed3. Estimate for breakage of points that will

never be redeemed

Frequent guest pays $250 in room revenue at a Dallas property and earns 2,500 reward points.

Hotel owner pays 5%-6% of room revenue to hotel corporation (Program manager).

$250 to hotel 2,500

reward points

$12.50 to $15.00







never be redeemed

Scenario repeats itself multiple times until frequent guest has acquired enough points to earn a free hotel stay.

Frequent guests pays $250 in room revenue at a Dallas property and earns 2,500 reward points.

Hotel owner pays 5%-6% of room revenue to hotel corporation.

$250 to hotel

2,500 reward points

$12.50 to $15.00







never be redeemed

Scenario repeats itself multiple times until frequent guest has acquired enough points to earn a free hotel stay.

Frequent guests pays $250 in room revenue at a Dallas property and earns 2,500 reward points.

Hotel owner pays 5%-6% of room revenue to hotel corporation.

$250 to hotel

2,500 reward points

$12.50 to $15.00







never be redeemed



Exhibit 54: How frequent guest program works—step three


This customer would have to stay roughly 20 nights to build enough points for a Hawaiian weekend stay.

Hawaiian hotel receives cash redemption value of hotel stay of $500 from hotel corporation�s general cash account. Either predetermined redemption value or percentage of current rack rate.

Frequent guest member redeems 50,000 points for a weekend at a Hawaiian property under the same brand name.

$500

Hotel Corporation (Program Manager) Balance sheet:

A. General Cash Account decreases by $500

B. Other liabilities decreases by amount equal to future redemption obligation ($500).

Hawaiian hotel receives cash redemption value of hotel stay of $500 from hotel corporation�s general cash account. Either predetermined redemption value or percentage of current rack rate.

Frequent guest member redeems 50,000 points for a weekend at a Hawaiian property under the same brand name.

$500

Hotel Corporation (Program Manager) Balance sheet:

A. General Cash Account decreases by $500

B. Other liabilities decreases by amount equal to future redemption obligation ($500).



Appendix I: industry terminology

Average daily rate (ADR): average daily rate achieved for domestic hotels.

Average weekly rate (AWR): average weekly rate achieved for extended-stay properties.

Central reservation system (CRS): database that compiles all property pricing and availability information for individual hotel companies.

Chain scale4: classifications of hotels into segments that are based primarily on the actual, system-wide average room rates of the major chains. Independent hotels are included in a separate category. The segments are Upper Upscale Chain, Upscale Chains, Midscale Chains with F&B, Midscale Chains without F&B, Economy Chains.

General distribution system (GDS): (Amadeus, SABRE, Galileo, Apollo, Worldspan) electronic network used by agents to book hotel, airline, and car reservations.

Franchise contracts: Companies whose franchise typically derives its revenues through a percentage of room revenues. This percentage is typically higher than a base fee percentage for management contracts as the hotel companies do not benefit from incentive fees.

Free independent traveler (FIT): free independent travelers are consumers not tied to business travel, convention, or group business. These consumers are typically leisure oriented.

Funds from operations (FFO): an industry-wide standard for measuring operating performance for lodging REITs; calculated as net income according to GAAP, plus real estate depreciation, any extraordinary charges and any repayments of principal on debt balances.

Location segment5: classifications dictated by physical location of the hotel.

• Urban—Hotels located in the Central Business District (CBD), usually the downtown area of large metropolitan markets (e.g., Atlanta, Boston, New York).

• Suburban—Hotels located in the suburban areas of metropolitan markets (e.g., College Park or Marietta, Georgia, near Atlanta).

• Highway—Hotels located on an interstate or other major road or in a small town or city (e.g., Evergreen, Alabama, or Colorado City, Texas).

• Airport—Hotels located within five miles (usually) of a major municipal airport.

• Resort—Hotels located within a market that attracts mostly leisure travelers such as Orlando, Florida, or Lake Tahoe, Nevada.

Management contracts: Companies who specialize in management contracts derive fees for managing the day-to-day operations for third-party owners. Management companies

4 "The U.S. Lodging Industry Today" (Lodging - Market Overview), February 1999, Smith Travel Research.




derive fees in three ways: (1) base fees usually taken as a percentage of overall revenues; (2) additional fees for services rendered for pre-opening development, purchasing, marketing, reservations, and advertising for the hotel owner; and (3) incentive fees that serve as an additional bonus for increased performance at the hotel profit level. Incentive fees are typically based on a percentage of overall profits and are usually only paid if a certain threshold level of profits is achieved.

Market price segments6: five categories of a metro STR market defined by actual or estimated average room rate:

• Luxury—top 15% of average room rates.

• Upscale—next 15% of average room rates.

• Mid-price—middle 30% of average room rates.

• Economy—next 20% of average room rates.

• Budget—lowest 20 % of average room rates.

Note: In rural or non-metro STR markets, the top 30% of average room rates are classified as Upscale price (i.e., there is no Luxury category) and other price brackets remain the same.

Occupancy rates: the percentage of room filled divided by the total number of rooms available; if occupancy rates increase.

Price/FFO: a valuation ratio defined as price divided by funds from operations. This multiple is used to value REITs instead of the more common P/E approach used in equity analysis, owing to lodging REITs’ large depreciation expenses.

RevPAR: Revenue per available room measures the occupancy times the average daily rate.

Switch (Pegasus): evolved as a result of the incompatibility between GDS and the hotel’s CRS as each CRS was developed with different languages and capabilities. Switches link the GDS to the CRS by deciphering the various CRS languages and translating the information into a readable form for the GDS.




Appendix II: additional sources of information

Websites American Resort Development Association: http:/www.arda.org

American Hotel and Lodging Association: http://www.ahma.com

Hotel Business: http://www.hotelbusiness.com

Hotel & Motel Management: http//www.hotelmotel.com

Hotel News Resource: http://www.hotelnewsresource.com

Smith Travel Research: http://www.str.com

Tourism Industries: http://tinet.ita.doc.gov

Travel Industry Association of America: http://www.tia.org

Timeshare Beat: http://www.thetimesharebeat.com

Company websites Accor: http://www.accor.com

Motel 6: http://www.motel6.com

Cendant Corporation: http://www.cendant.com

Wyndham Hotels and Resorts: http:// http://www.wyndham.com

Days Inn: http://www.daysinn.com

Howard Johnson: http://www.hojo.com

Knights Inn: http://www.knightsinn.com

Villager Lodge: http://www.villager.com

Ramada: http://www.ramada.com

Travelodge: http://www.travelodge.com

Super 8: http://www.super8.com

Wingate Inns: http://www.wingateinns.com

Fairmont Hotels & Resorts: http://www.fairmont.com

Four Seasons Hotels & Resorts : http://www.fourseasons.com

Hilton Hotels Corp.: http://www.Hilton.com

Host Hotels and Resorts: http://hosthotels.com



Hyatt Hotels: http://www.hyatt.com

InterContinental Hotels Group: http://www.ichotelsgroup.com/

Interstate Hotels & Resorts: http://www.ihrco.com

Marriott International: http://www.marriott.com

Millennium & Copthorne: http://www.millennium-hotels.com

NH Hoteles: http://www.nh-hoteles.com

Orient Express Hotels & Resorts: http://www.orientexpress.com

Sol Melia: http://www.solmelia.es

Starwood Hotels & Resorts: http://www.starwood.com

Strategic Hotels & Resorts: http://www.strategichotels.com

Whitbread: http://www.whitbread.co.uk

Publications and magazines Daily Lodging Report Asia-Pacific

Daily Lodging Report North America

Hotel Business

Hotel and Motel Management

Analyst certification Each of the analysts named below hereby certifies that, with respect to each company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Steve Kent, Julia Crowell.



Regional research team

Steven E. Kent, CFA, Managing Director Steve Kent, Managing Director, is the lodging, gaming, and cruise analyst at Goldman Sachs. He has been consistently ranked as one of the top analysts in his field by the Wall Street Journal, Institutional Investor, and the Greenwich Survey. Steve graduated, phi beta kappa and magna cum laude, from the State University of New York at Stony Brook with a B.A. in economics. He joined Goldman Sachs in 1985 to work in the Economic Research Group. Steve left in 1986 to continue his post-graduate studies in business economics/finance at Columbia University and went on to cover the retail sector as an associate analyst at another Wall Street firm for three years. In 1990, he received his M.B.A. from New York University, and rejoined Goldman Sachs to follow emerging growth companies. In 1995, Steven assumed responsibility for the restaurant, lodging, and gaming sectors.

Julia D. Crowell, Vice President Julia D. Crowell joined Goldman Sachs in March 1999 to work in the lodging and gaming group. She currently covers the lodging and cruise companies with Steven Kent and has primary coverage of the lodging REITs and motorcycle companies. Julia graduated magna cum laude with a B.A. in biology from Dartmouth College and completed the Bride Program at the Tuck School of Business in July 1998.

Jared Miller, Business Analyst Jared Miller, Business Analyst, joined Goldman, Sachs & Co. in June 2004. He works with Steve Kent in the Lodging, Gaming, and Cruise sectors. Jared has a B.B.A with an emphasis in accounting from the University of Michigan Business School.

New York: 1-212-902-6752 [email protected]

Chicago: 1-312-362-4775 [email protected]

New York: 1-212-934-0150 [email protected]



Disclo

sures



Coverage group(s) of stocks by primary analyst(s)

Compendium report: please see disclosures at http://www.gs.com/research/hedge.html

Company-specific regulatory disclosures


Distribution of ratings/investment banking relationships

Goldman Sachs Investment Research global coverage universe

Rating Distribution

OP/Buy IL/Hold U/Sell

26% 59% 15%

Investment Banking Relationships

OP/Buy IL/Hold U/Sell

58% 52% 47%Global

As of April 1, 2006, Goldman Sachs Global Investment Research had investment ratings on 2,048 equity securities.Goldman Sachs uses three ratings relative to each analyst's coverage universe - Outperform, In-Line and Underperform.See "Ratings, Coverage Views and related definitions" below. NASD/NYSE rules require a member to disclose thepercentage of its rated securities to which the member would assign a buy, hold, or sell rating if such a system were used.Although relative ratings do not correlate to buy, hold, and sell ratings across all rated securities, for purposes of theNASD/NYSE rules, Goldman Sachs has determined the indicated percentages by assigning buy ratings to securities ratedOutperform, hold ratings to securities rated In-Line, and sell ratings to securities rated Underperform, without regard to thecoverage views of analysts.

Price target and rating history chart(s)




Regulatory disclosures

Disclosures required by United States laws and regulations See company-specific regulatory disclosures above for any of the following disclosures required as to companies referred to in this report: manager or co-manager in a pending transaction; 1% or other ownership; compensation for certain services; types of client relationships; managed/co-managed public offerings in prior periods; directorships; market making and/or specialist role.

The following are additional required disclosures: Ownership and material conflicts of interest: Goldman Sachs policy prohibits its analysts, professionals reporting to analysts and members of their households from owning securities of any company in the analyst's area of coverage. Analyst compensation: Analysts are paid in part based on the profitability of Goldman Sachs, which includes investment banking revenues. Analyst as officer or director: Goldman Sachs policy prohibits its analysts, persons reporting to analysts or members of their households from serving as an officer, director, advisory board member or employee of any company in the analyst's area of coverage. Distribution of ratings: See the distribution of ratings disclosure above. Price chart: See the price chart, with changes of ratings and price targets in prior periods, above, or, if electronic format or if with respect to multiple companies which are the subject of this report, on the Goldman Sachs website at http://www.gs.com/research/hedge.html.

Additional disclosures required under the laws and regulations of jurisdictions other than the United States The following disclosures are those required by the jurisdiction indicated, except to the extent already made above pursuant to United States laws and regulations. Australia: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. Canada: Goldman Sachs Canada Inc. has approved of, and agreed to take responsibility for, this research in Canada if and to the extent it relates to equity securities of Canadian issuers. Analysts may conduct site visits but are prohibited from accepting payment or reimbursement by the company of travel expenses for such visits. Germany: See company-specific disclosures above for (i) any net short position or (ii) management or co-management of public offerings in the last five years as to covered companies referred to in this report. Hong Kong: Further information on the securities of covered companies referred to in this research may be obtained on request from Goldman Sachs (Asia) L.L.C. Japan: See company-specific disclosures as to any applicable disclosures required by Japanese stock exchanges, the Japanese Securities Dealers Association or the Japanese Securities Finance Company. Korea: Further information on the subject company or companies referred to in this research may be obtained from Goldman Sachs (Asia) L.L.C., Seoul Branch. Singapore: Further information on the covered companies referred to in this research may be obtained from Goldman Sachs (Singapore) Pte. (Company Number: 198602165W). United Kingdom: Persons who would be categorized as private customers in the United Kingdom, as such term is defined in the rules of the Financial Services Authority, should read this research in conjunction with prior Goldman Sachs research on the covered companies referred to herein and should refer to the risk warnings that have been sent to them by Goldman Sachs International. A copy of these risk warnings, and a glossary of certain financial terms used in this report, are available from Goldman Sachs International on request.

Ratings, coverage views, and related definitions

Our rating system requires that analysts rank order the stocks in their coverage groups and assign one of three investment ratings (see definitions below) within a ratings distribution guideline of no more than 25% of the stocks should be rated Outperform and no fewer than 10% rated Underperform. The analyst assigns one of three coverage views (see definitions below), which represents the analyst’s investment outlook on the coverage group relative to the group’s historical fundamentals and valuation. Each coverage group, listing all stocks covered in that group, is available by primary analyst, stock and coverage group at http://www.gs.com/research/hedge.html.

Definitions Outperform (OP). We expect this stock to outperform the median total return for the analyst's coverage universe over the next 12 months. In-Line (IL). We expect this stock to perform in line with the median total return for the analyst's coverage universe over the next 12 months. Underperform (U). We expect this stock to underperform the median total return for the analyst's coverage universe over the next 12 months. Not Rated (NR). The investment rating and target price, if any, have been removed pursuant to Goldman Sachs policy when Goldman Sachs is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances. Rating Suspended (RS). Goldman Sachs Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon. Coverage Suspended (CS). Goldman Sachs has suspended coverage of this company. Not Covered (NC). Goldman Sachs does not cover this company. Not Available or Not Applicable (NA). The information is not available for display or is not applicable. Not Meaningful (NM). The information is not meaningful and is therefore excluded.

Coverage views: Attractive (A). The investment outlook over the following 12 months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the following 12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. Cautious (C). The investment outlook over the following 12 months is unfavorable relative to the coverage group's historical fundamentals and/or valuation.

Current Investment List (CIL). We expect stocks on this list to provide an absolute total return of approximately 15%-20% over the next 12 months. We only assign this designation to stocks rated Outperform. We require a 12-month price target for stocks with this designation. Each stock on the CIL will automatically come off the list after 90 days unless renewed by the covering analyst and the relevant Regional Investment Review Committee.

Ratings definitions prior to November 4, 2002 RL = Recommended List. Expected to provide price gains of at least 10 percentage points greater than the market over the next 6-18 months. LL = Latin America Recommended List. Expected to provide price gains at least 10 percentage points greater than the Latin America MSCI Index over the next 6-18 months. TB = Trading Buy. Expected to provide price gains of at least 20 percentage points sometime in the next 6-9 months. MO = Market Outperformer. Expected to provide price gains of at least 5-10 percentage points greater than the market over the next 6-18 months. MP = Market Performer. Expected to provide price gains similar to the market over the next 6-18 months. MU = Market Underperformer. Expected to provide price gains of at least 5 percentage points less than the market over the next 6-18 months.



Global product; distributing entities

The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs, and pursuant to certain contractual arrangements, on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy.

This research is disseminated in Australia by Goldman Sachs JBWere Pty Ltd (ABN 21 006 797 897) on behalf of Goldman Sachs; in Canada by Goldman Sachs Canada Inc. regarding Canadian equities and by Goldman Sachs & Co. (all other research); in Germany by Goldman Sachs & Co. oHG; in Hong Kong by Goldman Sachs (Asia) L.L.C.; in Japan by Goldman Sachs (Japan) Ltd; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs JBWere (NZ) Limited on behalf of Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman, Sachs & Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union.

General disclosures in addition to specific disclosures required by certain jurisdictions

This research is for our clients only. Other than disclosures relating to Goldman Sachs, this research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various regulations may prevent us from doing so.

Goldman Sachs conducts a global full-service, integrated investment banking, investment management, and brokerage business. We have investment banking and other business relationships with a substantial percentage of the companies covered by our Global Investment Research Division.

Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and our proprietary trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, our proprietary trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research.

We and our affiliates, officers, directors, and employees, excluding equity analysts, will from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives (including options and warrants) thereof of covered companies referred to in this research.

This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of the investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Current options disclosure documents are available from Goldman Sachs sales representatives or at http://theocc.com/publications/risks/riskstoc.pdf. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments.

Our research is disseminated primarily electronically, and, in some cases, in printed form. Electronic research is simultaneously available to all clients.

Disclosure information is also available at http://www.gs.com/research/hedge.html or from Research Compliance, One New York Plaza, New York, NY 10004.

Copyright 2006 The Goldman Sachs Group, Inc.

No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of The Goldman Sachs Group, Inc.

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Goldman Sachs US Investment Research

Co-Directors of US ResearchDavid Tenney 1-212-902-6791 Anthony Carpet 1-212-902-6758

Accounting Michael A. Moran, CFA 1-212-357-3512

EconomicsJan Hatzius 1-212-902-0394

Portfolio strategyAbby Joseph Cohen, CFA 1-212-902-4095David J. Kostin 1-212-902-6781

AirlinesGlenn Engel, CFA 1-212-902-6753

Apparel, footwear & textilesMargaret Mager 1-212-902-3099

Banks, large-capLori B. Appelbaum 1-212-902-6846

Banks, mid-capLori B. Appelbaum 1-212-902-6846

BeveragesJudy E. Hong 1-212-902-0490

BiotechnologyMay-Kin Ho, Ph.D. 1-212-902-6723Meg Malloy, CFA 1-212-902-7839

Aerospace & defense electronicsGlenn Engel, CFA 1-212-902-6753

Chemicals, specialtyRobert Koort, CFA 1-212-357-4333

Computer services & IT consultingGregory Gould 1-212-902-7771Julio C. Quinteros, Jr. 1-415-249-7464

Commodities

Cosmetic, household, & personal care productsAmy Low Chasen 1-212-902-6748

Enterprise application & infrastructure softwareRick G. Sherlund 1-212-902-6790Sarah Friar 1-415-249-7436

Chemicals, commodityRobert Koort, CFA 1-212-357-4333

Paper & forest productsRichard Skidmore, CFA 1-212-357-5509

Publishing & information servicesPeter P. Appert, CFA 1-415-249-7480

REITsJonathan Habermann 1-917-343-4260

RestaurantsSteven T. Kron, CFA 1-212-902-1896

Retailing, department storesAdrianne Shapira 1-212-357-4174

Retailing, food & drugJohn Heinbockel 1-212-902-6835

Semiconductor capital equipmentJames Covello 1-212-902-1918

Small companiesJonathan Shapiro 1-212-902-8458

Telecom services - wireline/wirelessJason Armstrong, CFA 1-212-902-8156

Washington researchAlec Phillips 1-202-637-3746

Telecom equipment - wireline/wirelessBrantley Thompson 1-212-902-9823

Storage networkingLaura Conigliaro 1-212-902-5926

Technology strategyLaura Conigliaro 1-212-902-5926Rick G. Sherlund 1-212-902-6790

Semiconductor devicesJames Covello 1-212-902-1918

Pharmaceuticals, majorJames Kelly 1-212-357-7536

PC hardwareLaura Conigliaro 1-212-902-5926

Retail, softlines specialty Margaret Mager 1-212-902-3099

Enterprise hardwareLaura Conigliaro 1-212-902-5926

Entertainment Anthony Noto 1-212-357-1849

Equity derivativesMaria Grant, CFA 1-212-855-0070

Gaming and lodging, cruisesSteven Kent, CFA 1-212-902-6752

Oil services & equipment

Healthcare technology & distributionChristopher McFadden, CFA 1-212-357-0136

Imaging technologyJack L. Kelly, CFA 1-212-902-6764

Insurance/lifeJoan H. Zief 1-212-902-6778

Insurance/nonlifeThomas V. Cholnoky 1-212-902-3408

Integrated oilArjun N. Murti 1-212-357-0931

Internet Anthony Noto 1-212-357-1849

Medical supplies & devicesLawrence Keusch 1-617-204-2051

Metals & mining & steelAldo Mazzaferro, CFA 1-212-902-9916Oscar Cabrera 1-212-357-4290Hongyu Cai 1-212-902-0575

Multi-industryJack L. Kelly, CFA 1-212-902-6764Deane M. Dray, CFA 1-212-902-2451

Managed careMatthew Borsch, CFA 1-212-902-6784

Oil & gas exploration & productionArjun N. Murti 1-212-357-0931

Equity trading strategies

Cable, satellite & towersLale Topcuoglu 1-212-902-9091

Healthcare facilitiesChristopher McFadden, CFA 1-212-357-0136

Food

Retail, hardlinesMatthew J. Fassler 1-212-902-6740

Radio & TV broadcastingMark Wienkes, CFA, CPA 1-212-357-1986

Electric utilitiesMichael Lapides 1-212-357-6307

Autos & auto partsRobert Barry 1-212-902-5677

Energy MLPsDavid Chiaro 1-713-654-8481

Small & mid-cap coverageChris Hussey 1-212-902-7564

Asset managersMarc Irizarry 1-212-902-4175

Pharmaceuticals, specialtyJames Kelly 1-212-357-7536 Randall Stanicky, CFA 1-212-357-3292

TobaccoJudy E. Hong 1-212-902-0490Daniel Henriques, CFA 1-212-357-4312

Jeffrey Currie 44-20-7774-6112

Lewis Segal 1-212-357-4322Dominic Wilson 1-212-902-5924

Steven T. Kron, CFA 1-212-902-1896


goldman sachs us lodging primer 2jun06[1]

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