ICF International, Inc. (ICFI) FY 2021 MD&A

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in Item 8. “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions, such as statements of our plans, objectives, expectations, and intentions. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report on Form 10-K. Our actual results could differ materially from those anticipated in the forward-looking statements. Factors that could cause or contribute to our actual results differing materially from those anticipated include those discussed in “Risk Factors” and elsewhere in this Annual Report on Form 10-K. This section of this Form 10-K generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2020 items and year-to-year comparisons between 2020 and 2019 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, which was filed with the SEC on February 26, 2021, and is incorporated by reference into this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

OVERVIEW AND OUTLOOK

We provide professional services and technology-based solutions to government and commercial clients. Our services include management, marketing, technology, and policy consulting and implementation services. We help our clients conceive, develop, implement, and improve solutions that address complex business, natural resource, social, technological, and public safety issues. Our services primarily support clients that operate in four key markets:

• Energy, Environment, and Infrastructure;

• Health, Education, and Social Programs;

• Safety and Security; and

• Consumer and Financial.

Drawing from our domain knowledge and staff experience in working in multi-disciplinary teams for clients in a variety of markets, we provide services to our diverse client base that deliver value throughout the entire life cycle of a policy, program, project, or initiative. Our primary services include:

• Advisory Services;

• Program Implementation Services;

• Analytics Services;

• Digital Services; and

• Engagement Services.

Our clients utilize our services because we combine diverse institutional knowledge and experience with the deep subject matter expertise of our highly educated staff, which we deploy in multi-disciplinary teams. We have successfully worked with many of our clients for decades, with the result that we have a thorough and nuanced perspective of their objectives and needs. We serve both governmental and commercial clients. Our government clients include those from departments and agencies of the federal government, state and local governments, and international governments. Our government efforts include work performed under subcontract agreements to commercial clients whose ultimate customer is government agencies and departments.

Our largest clients are U.S. federal government departments and agencies. In fact, our federal government clients have included every cabinet-level department, most significantly HHS, DoS, and DoD. Federal government clients generated approximately 47%, 44%, and 38% of our revenue in 2021, 2020, and 2019, respectively. State and local government clients generated approximately 15%, 15%, and 19% of our revenue in 2021, 2020, and 2019, respectively. International government clients generated approximately 9%, 6%, and 8% of our revenue in 2021, 2020, and 2019, respectively.

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We also serve a variety of commercial clients worldwide, including: airlines, airports, electric and gas utilities, health care companies, banks and other financial services companies, transportation, travel and hospitality firms, non-profits/associations, manufacturing firms, retail chains, and distribution companies. Our commercial clients, which include clients outside the U.S., generated approximately 29%, 35%, and 35% of our revenue in 2021, 2020, and 2019, respectively.

We report operating results and financial data as a single segment based on the consolidated information used by our chief operating decision-maker in evaluating the financial performance of our business and allocating resources. Our single segment represents our core business: professional services for government and commercial clients. Although we describe our multiple service offerings to clients that operate in four markets to provide a better understanding of the scope and scale of our business, we do not manage our business or allocate our resources based on those service offerings or client markets. Rather, on a project-by-project basis, we assemble the best team from throughout the enterprise to deliver highly customized solutions that are tailored to meet the needs of each client.

Notwithstanding the near-term impact of COVID-19 and its variants, we believe that, in the long-term, demand for our services will continue to grow as government, industry, and other stakeholders seek to address critical long-term societal and natural resource issues due to heightened concerns about the environment and use of clean energy and energy efficiency; health promotion, treatment, and cost control; the means by which healthcare can be delivered effectively on a cross-jurisdiction basis; natural disaster relief and rebuild efforts; and ongoing homeland security threats. In the wake of the major hurricanes (Harvey, Ida, Irma, Maria, Laura and Michael) that devastated communities in Texas, Florida, North Carolina, Louisiana, the U.S. Virgin Islands, and Puerto Rico, the affected areas remain in various stages of relief and recovery efforts. We believe our prior and current experience with disaster relief and rebuild efforts, including those from Hurricanes Katrina and Rita and Superstorm Sandy, put us in a favorable position to continue to provide recovery and housing assistance, and environmental and infrastructure solutions, including disaster mitigation, on behalf of federal departments and agencies, state, territorial and local jurisdictions, and regional agencies.

We also see significant opportunity to further leverage our digital and client engagement capabilities across our commercial and government client base. Our future results will depend on the success of our strategy to enhance our client relationships and seek larger engagements that span the entire program life cycle, and to complete and successfully integrate additional strategic acquisitions. We will continue to focus on building scale in our vertical and horizontal domain expertise, developing business with both our existing government and commercial clients as well as new customers, and replicating our business model in selective geographies. In doing so, we will continue to evaluate strategic acquisition opportunities, such as our recent acquisitions of ITG in 2020 and ESAC and Creative Systems in 2021, that enhance our subject matter knowledge, broaden our service offerings, and/or provide scale in specific geographies. Although we continue to see favorable long-term market opportunities, there are certain business challenges facing all government service providers. Administrative and legislative actions by the federal government to address changing priorities or in response to the budget deficit could have a negative impact on our business, which may result in a reduction to our revenue and profit and adversely affect cash flow. Similarly, the very nature of opportunities arising out of disaster recovery mean they can involve unusual challenges. Factors such as the overall stress on communities and people affected by disaster recovery situations, political complexities and challenges among involved government agencies, and a higher-than-normal risk of audits and investigations may result in a reduction to our revenue and profit and adversely affect cash flow. However, we believe we are well positioned to provide a broad range of services in support of initiatives that will continue to be priorities to the federal government, as well as to state and local and international governments and commercial clients. We believe that the combination of internally generated funds, available bank borrowings, and cash and cash equivalents on hand will provide the required liquidity and capital resources necessary to fund on-going operations, potential acquisitions, customary capital expenditures, and other working capital requirements.

Our results of operations and cash flows may vary significantly from quarter to quarter depending on a number of factors, including, but not limited to:

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Because a significant portion of our expenses (such as personnel, facilities, and related costs) are fixed in the short-term, contract performance and variation in the volume of activity, as well as in the number and volume of contracts commenced or completed during any year, may cause significant variations in operating results from year to year. We generally have been able to price our contracts in a manner that accommodates the rates of inflation experienced in recent years, although we cannot ensure that we will be able to do so in the future.

IMPACT OF THE COVID-19 PANDEMIC

On March 11, 2020, the World Health Organization characterized the novel strain of coronavirus disease COVID-19 as a global pandemic. There continues to be significant uncertainty as to the effects of this pandemic on the global economy, which may impact, among other things, our operations, balance sheet, results of operations or cash flows. Adverse events such as health-related concerns about working in our offices or our client’s offices, the inability to travel, the potential impact on our employees, clients, subcontractors and other suppliers and business partners, a slow-down in customer decision-making that affects procurement cycles, a reprioritization of client spending, and other matters affecting the general work and business environment have harmed, and could continue to harm, our business and delay the implementation of our business strategy. We cannot fully anticipate all the ways in which the current global health crisis, economic disruption, and financial market conditions could adversely impact our business in the future. The long duration of the pandemic, the advent of new strains of the virus, and challenges faced in the vaccination of eligible individuals, continue to create uncertainty and could have an adverse effect on our business, financial position, results of operations and/or cash flows.

We are primarily a service business, and our staffing, and that of our subcontractors, has been maintained, substantially on a work from home basis, fortunately with little COVID-19 illness among our staff. To date, we have experienced continuity in the majority of our work for our government clients, which accounted for approximately 71% of our revenues for the year ended December 31, 2021. There have been postponements of events and challenges around project work requiring travel and personal contact to perform services under the contracts, but overall, our government clients have continued to require our services. There has also been additional demand from federal agencies such as the Center for Disease Control and Prevention, the Department of Health and Human

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Services, and the Federal Emergency Management Agency, as well as state and local and international government agencies.

Of the remaining 29% of our total revenue for the year ended December 31, 2021, the majority was generated from commercial energy markets and commercial marketing services. In commercial energy, where we work primarily for utility clients, we have experienced trends similar to those with our government clients, although some aspects of energy efficiency programs have been altered to reduce direct interaction with consumers. The commercial marketing services includes public event management and marketing technology, which was impacted based on the deferral or cancellation of marketing events. Some of our commercial clients perform work in travel-related markets and have been severely impacted by the COVID-19 pandemic and the restriction upon travel worldwide. As a result, we continue to monitor that business area closely. These elements of commercial marketing services represented less than 9% of our total company-wide revenues for the year ended December 31, 2021, respectively.

We are monitoring the evolving situation related to the COVID-19 pandemic and continue to work with our stakeholders to assess further possible implications to our business and to take actions in an effort to mitigate adverse consequences. To protect employee health and safety while COVID-19 remains a threat, we plan to continue to deliver a majority of our services to clients remotely until we are ready for a transition to an on-office environment. During the third quarter of 2021, we started our phased return to in-office work in the U.K. and China on a reduced capacity. However, based on the continued level of new cases related to the Delta and Omicron variants of COVID-19, we have pushed back our phased return to in-person operations at our U.S., Puerto Rico, Canada, Belgium, India, and Africa office locations to mid-to-late first quarter of 2022. Additionally, in response to President Biden’s Executive Order 14042 which require federal contractors to be vaccinated against COVID-19 by December 8, 2021 and later amended to January 4, 2022, we have implemented a requirement for our U.S. employees to be fully vaccinated or receive an approved exemption/accommodation by November 30 regardless of employment type or work location—remote, hybrid, or on-site.

In 2020, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was passed that contained a provision that allow federal contractors to seek specified reimbursement for certain employees who are unable to perform their contract requirements due to government restrictions. We deferred payment of approximately $20.9 million of employer Social Security taxes during the twelve months ended December 31, 2020, of which 50% has been repaid as of December 31, 2021 and the remaining 50% is expected to be repaid by September 30, 2022. We did not defer any additional Social Security taxes in 2021.

As part of management actions to counter the impact of COVID-19, we have aligned our costs with anticipated revenues. In the U.S. and in our international operations, we used staff reductions, furloughs, and other temporary wage reduction programs in response to the pandemic during 2020. However, during 2021 we did not have as many staff reductions, furloughs, or wage reductions as a result of COVID-19 as we had previously experienced in 2020. We also previously participated in three international government subsidy programs whose objective is to encourage eligible companies to keep employees on the payroll during the COVID-19 pandemic. We minimally participated in two subsidy programs during the first quarter of 2021 but did not participate in such programs subsequently.

BUSINESS COMBINATIONS

A key element of our growth strategy is to pursue acquisitions. During the previous three fiscal years, we acquired a total of four companies including:

Incentive Technology Group, LLC – In January 2020, we completed the acquisition of ITG, one of the leading providers of cloud-based platform services to the federal government.

Eco-Tech Consultants, Inc. – In December 2020, we completed the acquisition of Eco-Tech, an ecological consulting firm located in Louisville, Kentucky that provides a range of ecological services across the Eastern United States.

ESAC – In November 2021, we acquired ESAC, one of the leading specialized providers of advanced health analytics, research data management and bioinformatics solutions to U.S. federal health agencies.

Creative Systems and Consulting – In December 2021, we acquired Creative Systems, a premier provider of IT modernization and digital transformation solutions to U.S. federal agencies.

CRITICAL ACCOUNTING ESTIMATES

Our discussion of our financial condition and results of operations is based on our consolidated financial statements prepared in accordance with U.S. GAAP.  The preparation of these consolidated financial statements requires us to make certain estimates, assumptions, and judgments that affect the reported amounts of assets,

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liabilities, revenue, and expenses during the reporting period. If any of these estimates or judgments prove to be incorrect, our reported results could be materially affected. Actual results may differ significantly from our estimates under different assumptions or conditions.

We believe that the estimates, assumptions and judgments involved in the accounting practices described below have the greatest potential impact on our financial statements and, therefore, consider them to be critical accounting policies. Significant accounting estimates are more fully described and discussed in “Note 2—Summary of Significant Accounting Policies” in the “Notes to Consolidated Financial Statements.”

Revenue Recognition

We generate our revenue by primarily providing services and technology-based solutions for clients. We enter into agreements with clients that create enforceable rights and obligations and for which it is probable that we will collect the consideration to which we will be entitled as services and solutions are provided to the client. We generally recognize revenue over time as services and performance obligations are transferred to the client, based on the extent of progress towards satisfaction of the performance obligation. The selection of the method used to measure progress requires judgment and, among other things, is dependent on the contract type selected by the client during contract negotiation and the nature of the services and solutions to be provided.

When a performance obligation is billed using a time-and-materials contract type, we use the right to invoice practical expedient output progress measures to estimate revenue earned based on hours worked in contract performance at negotiated billing rates. Fixed-price level-of-effort contracts are substantially similar to time-and-materials contracts except that we are required to deliver a specified level of effort over a stated period of time. For these contracts, we estimate revenue earned using contract hours worked at negotiated bill rates as we deliver the contractually required workforce.

For cost-based contracts, we recognize revenue as a single performance obligation based on contract costs incurred, as we become contractually entitled to reimbursement of the contract costs, plus a most likely estimate of award or incentive fees earned on those costs even though final determination of fees earned occurs after the contractually stipulated performance assessment period ends.

For performance obligations requiring the delivery of a service for a fixed price, we use the ratio of actual costs incurred to total estimated costs at completion, or EAC, provided that costs incurred (an input method) represents a reasonable measure of progress towards the satisfaction of a performance obligation, in order to estimate the portion of total revenue earned. Contract costs that are not reflective of our progress toward satisfying a performance obligation are not included in the calculation of the measure of progress. We estimate the EAC by making certain assumptions and judgments such as level of efforts from internal staff and/or subcontractors and cost of materials needed to complete the tasks. Our cost estimate is based on our prior experience and expertise in delivery of similar services which allow us to make reasonable assumptions and estimates that is close to actual costs to complete the obligations.  However, changes in the scope or complexity of work, availability of materials needed, or performance could cause a change in the EAC.  We routinely review EACs for changes that could materially impact our measurement of progress toward completion of the performance obligations, and adjust our revenue in the period that the changes occur.  When a contract EAC exceeds the contract value, we recognize the loss in the same period of determination.

In some fixed price service contracts, we perform services of a recurring nature, such as maintenance and other services of a “stand ready” nature. For these contracts, we have the right to consideration in an amount that corresponds directly with the value that the client has received. Therefore, we record revenue on a time-elapsed basis to reflect the transfer of control to the client throughout the contract.

Our contracts may include variable considerations such as award fees and incentives that may increase or decrease the transaction price.  The actual amounts are typically determined and awarded at the end of a performance period and the final awarded amount is based on achieving certain performance metrics, program milestones, or cost targets at the customer’s discretion.  We estimate the most likely amount expected to achieve based on our prior history in providing the services to the customer or, if no history exists, we constrain the variable consideration until the initial determination by the customer.

Goodwill and Other Intangible Assets

We allocate the purchase price of an acquired business to the tangible assets and separately identifiable intangible assets acquired, less liabilities assumed, based on their respective fair values (except for contract assets and contract liabilities after the adoption of Accounting Standards Update 2021-08, Business Combinations: Accounting for Contract Assets and Contract Liabilities from Contracts with Customers.) Such fair value assessment requires us to make judgments and estimates based on information that exists at the date of the acquisition, which

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may subsequently change. We have up to one year from the acquisition date to adjust the amounts recorded for assets acquired and liabilities assumed from the acquisition based on new information gathered.

Goodwill represents the excess of costs over the fair value of net assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead are reviewed annually for impairment, or more frequently if impairment indicators arise. Intangible assets with estimable useful lives are amortized over such lives and reviewed for impairment if impairment indicators arise. We perform our impairment analysis of goodwill and intangible assets acquired in business acquisitions as of the first day of the fourth quarter of each year or whenever an event or circumstance indicates that an impairment may have been incurred.  For our analysis, we perform a qualitative assessment of whether it is more likely than not that the reporting unit's fair value is less than its carrying amount. If, after completing the qualitative assessment, we determine that it is more likely than not that the estimated fair value of the reporting unit exceeded the carrying amount, we may conclude that no impairment exists. If we conclude otherwise, a goodwill impairment test must be performed, which includes a comparison of the fair value of the reporting unit to its carrying amount and recognizing, as an impairment loss, the difference of the estimated fair value of the reporting unit over its carrying amount.

Accounting for Income Taxes

Our provisions for federal, state, and foreign income taxes are calculated from consolidated income based on current tax laws and any changes in tax rates from the rates used previously in determining the deferred tax assets and liabilities from temporary differences between financial statement carrying amounts and amounts on our tax returns.

We recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. We evaluate our ability to benefit from all deferred tax assets and establish valuation allowances for amounts we believe are not more likely than not to be realized.

We use a more-likely-than-not recognition threshold based on the technical merits of the income tax position taken to evaluate uncertain tax positions. Uncertain tax positions that meet the more-likely-than-not recognition threshold are measured in order to determine the tax benefit recognized in the financial statements.

Recent Accounting Pronouncements

New accounting standards are discussed in “Note 2—Summary of Significant Accounting Policies” in the “Notes to Consolidated Financial Statements.”

SELECTED KEY METRICS

In order to evaluate operations, we track revenue by key metrics that provide useful information about the nature of our operations. Client markets provide insight into the breadth of our expertise. Client type is an indicator of the diversity of our client base. Revenue by contract mix provides insight in terms of the degree of performance risk that we have assumed. Significant variances in the key metrics tables that are provided below are discussed under the revenue section of the results of operations.

Client markets

The following table shows revenue generated from client markets as a percent of total revenue for the periods indicated. For each client, we have attributed all revenue from that client to the market we consider to be the client’s primary market, even if a portion of that revenue relates to a different market. Certain minor revenue amounts reported in the prior years have been reclassified within key market categories based on our current view of the client’s primary market in order to increase comparability of the current year to prior years.

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Our primary clients are the agencies and departments of the federal government and commercial clients. Most of our revenue is from contracts on which we are the prime contractor, which we believe provides us strong client relationships. In 2021, 2020, and 2019, approximately 91%, 92%, and 92% of our revenue, respectively, was from prime contracts.

Client type

The table below shows our revenue by type of client as a percentage of total revenue for the periods indicated. Certain immaterial revenue amounts in the prior years have been reclassified due to minor adjustments and reclassification within client type.

Contract mix

Contract mix varies from year to year due to numerous factors, including our business strategies and the procurement activities of our clients. Unless the context requires otherwise, we use the term “contracts” to refer to contracts and any task orders or delivery orders issued under a contract. There are three main types of contracts: time-and-materials contracts, fixed-price contracts, and cost-based contracts. For a detailed discussion of contract types, see “Critical Accounting Policies - Revenue Recognition” above.

The following table shows the approximate percentage of our revenue for each of these types of contracts for the periods indicated. Certain immaterial revenue amounts in the prior years have been reclassified due to minor adjustments and reclassification within contract type.

Payments we received on cost-based contracts with the federal government are provisional payments subject to adjustment upon audit by the government. Such audits have been finalized through 2011 for NIH-cognizant indirect rates and through 2015 for USAID-cognizant indirect rates, and any adjustments have been immaterial. Contract revenue for subsequent periods has been recorded in amounts that are expected to be realized on final audit and settlement of costs in those years.

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RESULTS OF OPERATIONS

The following table sets forth certain items from our consolidated statements of comprehensive income for the years ended December 31, 2021 and 2020, expresses these items as a percentage of revenue for the periods indicated and the period-over-period rate of change in each of them. Our discussion of the items for the years ended December 31, 2020 and 2019 can be found in our Annual Report on Form 10-K for the year ended December 31, 2020, which was filed with the SEC on February 26, 2021.

Years Ended December 31, 2021 and 2020

(dollars in thousands)

Year ended December 31, 2021 compared to year ended December 31, 2020

Revenue. Revenue for the year ended December 31, 2021, was $1,553.0 million, compared to $1,506.9 million for the year ended December 31, 2020, representing an increase of $46.2 million or 3.1%. The increase in revenue was primarily from our federal government clients of $68.1 million, or 10.2%, international government clients of $42.7 million, or 45.6%, and state and local government clients of $14.3 million, or 6.5%, offset by a decrease in commercial clients of $78.8 million, or 15.0%, mainly due to completion of a large contract that primarily involved pass-through revenue. See “Note 11—Revenue Recognition” in the “Notes to Consolidated Financial Statements” for additional information. The increase in federal government revenue was driven by increases of $63.4 million, or 14.4%, and $10.1 million, or 8.6%, from our health, education, and social programs and our energy, environment, and infrastructure client markets, respectively, offset by a decrease of $5.4 million, or 4.8%, in revenue from our safety and security client market. The increase in international government revenue was primarily driven by $28.2 million, or 100.5%, $13.9 million, or 24.1%, and $0.6 million, or 6.9%, from our energy, environment, infrastructure and our health, education, and social programs, and safety and security client markets, respectively. Our state and local government revenue increased from our health, education, and social programs client market by $23.3 million, or 42.2%, offset by decreases in revenue from our energy, environment, and infrastructure client market of $8.2 million, or 5.0%, and from our safety and security client market of $0.8 million, or 50.9%. Our commercial revenue decreased by $78.8 million was primarily driven by a decrease of $100.0 million from our health, education, and social programs client market, offset by increases of $15.1 million, $5.8 million, and $0.3 million from our energy, environment, and infrastructure, consumer and financial, and safety and security client markets, respectively. The government and commercial revenues as a percent of total revenue was 71% and 29% for the year ended December 31, 2021 compared with 65% and 35% for the prior year.

Direct costs. Direct costs for the year ended December 31, 2021 were $979.6 million compared to $972.4 million for the year ended December 31, 2020, an increase of $7.2 million or 0.7%. The increase in direct costs was primarily due to an increase of $27.4 million in direct labor and associated fringe benefits costs and $28.0 million in sub-contractor costs, offset by a decrease of $48.2 million in direct materials and other direct costs. The direct labor and associated fringe benefits costs increase of $27.4 million was the result of new business awards and growth on existing contracts which required additional headcounts, as well as higher utilization from our employees in support of our work for our clients, particularly our international government clients, as well as an increase in medical benefits incurred during the year ended December 31, 2021 as compared to 2020. For the year ended December 31, 2021, direct labor and associated fringe benefits costs as a percentage of direct costs was 54.8% compared to 52.3% for the same period in 2020. The increase in sub-contractor costs of $28.0 million year over year was primarily due to additional work for our international government clients during the year ended December 31, 2021 compared to

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the year ended December 31, 2020. The decline in direct materials and other direct costs of $47.8 was primarily due to fewer media buys during the year ended December 31, 2021 compared to the year ended December 31, 2020. Direct costs as a percent of revenue was 63.1% for the year ended December 31, 2021 compared to 64.5% for 2020.

Indirect and selling expenses. Indirect and selling expenses generally include our management, facilities, and infrastructure costs for all employees and the salaries and wages related to indirect activities, including stock-based and cash-based incentive compensation provided to employees whose compensation and other benefit costs are included in indirect and selling expenses, plus associated fringe benefits not directly related to client engagements.

Indirect and selling expenses for the year ended December 31, 2021, were $430.6 million compared to $411.6 million for 2020, an increase of $19.0 million or 4.6%. The increase in indirect and selling expenses was primarily due to an increase in indirect labor and associated fringe benefits costs and other compensation costs of $17.4 million, and in general and administrative costs of $1.6 million. The increase in indirect labor, associated fringe benefits costs, and other compensation costs was due to higher headcounts for the year ended December 31, 2021 as compared to the same period in 2020. Indirect and selling expenses as a percent of revenue increased slightly to 27.7% for the year ended December 31, 2021, compared to 27.3% for the year ended December 31, 2020.

Depreciation and amortization. Depreciation and amortization was $19.5 million for the year ended December 31, 2021, compared to $20.4 million for the prior year, a decrease of $0.9 million or 4.5%. The decrease was the result of certain assets becoming fully depreciated and amortized.

Amortization of intangible assets. Amortization of intangible assets for the year ended December 31, 2021 was $12.5 million compared to $13.3 million for the prior year. The $0.8 million decrease was primarily due to reduced levels of amortization of intangible assets associated with prior acquisitions offset by amortization of intangible assets acquired from our acquisitions of ITG in 2020 and ESAC in 2021.

Operating income. For the year ended December 31, 2021, operating income was $110.9 million compared to $89.1 million for the prior year, an increase of $21.8 million or 24.5%. Operating income as a percent of revenue was 7.1% for the year ended December 31, 2021 compared to 5.9% for the prior year. The changes were largely due to an increase in revenue of $46.2 million, offset by an increase in indirect and selling expenses of direct costs of $19.0 million and direct costs of $7.2 million.

Interest expense. For the year ended December 31, 2021, interest expense was $10.3 million, compared to $13.9 million for the prior year, a decrease of $3.6 million or 26.2%. The decrease in interest expense for the year ended December 31, 2021 was due to our lower average debt balance of $335.5 million in 2021 compared to $428.0 in 2020 as well as our lower average interest rate of 1.6% in 2021 compared to 2.3% in 2020.

Other expense. For the year ended December 31, 2021, other expense was $0.6 million which was similar to other expense of $0.5 million for the prior year.

Provision for income taxes. The effective income tax rate for the years ended December 31, 2021 and December 31, 2020, was 28.9% and 26.4%, respectively. Our effective tax rate, including state and foreign taxes net of federal benefit for the year ended December 31, 2021, was higher than the prior year primarily due to permanent differences related to executive compensation costs not deductible for tax purposes, return to provisional tax adjustments from the prior year, and adjustments of valuation allowance on certain deferred tax assets, offset by tax benefits for stock-based compensation, reversal of reserves for unrecognized tax benefits, and permanent non-taxable income.

NON-GAAP MEASURES

These following tables provide reconciliations of financial measures that are not U.S. GAAP (“non-GAAP”) to the most applicable U.S. GAAP measures. While we believe that these non-GAAP financial measures may be useful in evaluating our financial information, they should be considered supplemental in nature and not as a substitute for financial information prepared in accordance with U.S. GAAP. Other companies may define similarly titled non-GAAP measures differently and, accordingly, care should be exercised in understanding how we define these measures.

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Service Revenue

Service revenue represents revenue less subcontractor and other direct costs (which include third-party materials and travel expenses). Service revenue is not a recognized term under U.S. GAAP and should not be considered an alternative to revenue as a measure of operating performance. This presentation of service revenue may not be comparable to other similarly titled measures used by other companies because other companies may use different methods to prepare similarly titled measures. We believe service revenue is a useful measure to investors since, as a consulting firm, a key metric is revenue generated from the services our employees provide to our clients. The table below presents a reconciliation of revenue to service revenue for the periods indicated:

EBITDA and Adjusted EBITDA

Earnings before interest and other income and/or expense, tax, and depreciation and amortization (“EBITDA”) is a measure we use to evaluate operating performance. We believe EBITDA is useful in assessing ongoing trends and, as a result, may provide greater visibility in understanding our operations.

Adjusted EBITDA is EBITDA further adjusted to eliminate the impact of certain items that we do not consider to be indicative of the performance of our ongoing operations. We evaluate these adjustments on an individual basis based on both the quantitative and qualitative aspects of the item, including their size and nature, as well as whether or not we expect them to occur as part of our normal business on a regular basis. We believe that the adjustments applied in calculating adjusted EBITDA are reasonable and appropriate to provide additional information to investors.

EBITDA and Adjusted EBITDA are not recognized terms under U.S. GAAP and should not be used as alternatives to net income as a measure of operating performance. This presentation of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures used by other companies because other companies may use different methods to prepare similarly titled measures. EBITDA and Adjusted EBITDA are not intended to be measures of free cash flow for management’s discretionary use as these measures do not include certain cash requirements such as interest payments, tax payments, capital expenditures and debt service.

A reconciliation of net income to EBITDA and adjusted EBITDA follows:

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Non-GAAP Diluted Earnings per Share

Non-GAAP diluted EPS represents diluted EPS excluding the impact of certain items such as impairment of intangible assets, acquisition expenses, severance for staff realignment, facility consolidations and office closures, certain adjustments to the allowance for expected credit losses and certain charges related to the retirement of our Executive Chair (which are also excluded from Adjusted EBITDA, as described further above), as well as the impact of amortization of intangible assets related to our acquisitions and income tax effects. While these adjustments may be recurring and not infrequent or unusual, we do not consider these adjustments to be indicative of the performance of our ongoing operations. Non-GAAP diluted EPS is not a recognized term under U.S. GAAP and is not an alternative to basic or diluted EPS as a measure of performance. This presentation of non-GAAP diluted EPS may not be comparable to other similarly titled measures used by other companies because other companies may use different methods to prepare similarly titled measures. We believe that the supplemental adjustments applied in calculating non-GAAP diluted EPS are reasonable and appropriate to provide additional information to investors.

The following table presents a reconciliation of diluted EPS to non-GAAP diluted EPS for the periods indicated:

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LIQUIDITY AND CAPITAL RESOURCES

Liquidity and Borrowing Capacity. Short-term liquidity requirements are created by our use of funds for working capital, capital expenditures, debt service, dividends, and share repurchases. We expect to meet these requirements through a combination of cash flow from operations and borrowings. Our primary source of borrowings is from our Credit Facility. As of December 31, 2021, we had $355.7 million, or $283.8 million after taking into account the financial and performance-based limitations, available under the Credit Facility to fund our ongoing operations, future acquisitions, dividend payments, and share repurchase program. Should the need arise, we intend to increase our borrowing capacity in the future to provide us with adequate working capital to continue our ongoing operations.

In March 2020, the World Health Organization characterized the novel COVID-19 virus as a global pandemic. Although we continue to face risks and uncertainties related to COVID-19 and its variants, to date we have not experienced any significant impacts on our liquidity and capital resources which remain available to us.

Material Cash Requirements from Contractual Obligations.  As of December 31, 2021, contractual obligations that require a material use of cash include repayments of our long-term debt and operating lease obligations for facilities and equipment.

On March 3, 2020, we entered into the First Amendment (the “First Amendment”) to the Fifth Amended and Restated Business Loan and Security Agreement, originally entered on May 17, 2017, with a group of 10 lenders (the “Credit Facility”) that increased our borrowing capacity by $200.0 million through the addition of a $200.0 million term loan to the Credit Facility. The First Amendment also made certain other changes to the Credit Facility as described in “Note 10—Long-Term Debt” in the “Notes to Consolidated Financial Statements”. During the fourth quarter of 2021, we drew upon our Credit Facility to fund the acquisitions of ESAC and Creative Systems of approximately $17.3 million and $159.5 million, respectively.  At December 31, 2021, our outstanding Credit Facility balance was $421.6 million, net of unamortized debt issuance costs, of which $10.0 million is due in 2022, $13.8 million in 2023, $15.0 million in 2024, and the remaining $384.8 million due upon maturity in 2025.  Assuming that our interest rate on the Credit Facility is the same as on December 31, 2021, we anticipates our interest payments on the debt to be approximately $4.0 million in 2022, $3.9 million in 2023, $3.7 million in 2024, and $0.6 million in 2025.  The estimates do not take into accounts future drawdowns and repayments on the debt or changes in the variable interest rate as described in Note 10—Long-Term Debt” in the “Notes to Consolidated Financial Statements”, and actual interest may be different.

At December 31, 2021, we have operating leases for facilities and equipment with remaining terms ranging from 1 to 17 years.  Our current and long-term operating lease liabilities of $226.7 million at December 31, 2021 represent the present value of the minimum payments required under the non-cancellable leases, and the actual cash payments total $280.1 million.  The lease payment obligations by year are further discussed in “Note 7—Leases” in the “Notes to Consolidated Financial Statements.”

Financial Condition. There were several changes in our consolidated balance sheet during the year ended December 31, 2021 compared to the consolidated balance sheet as of December 31, 2020. The more significant changes are discussed below.

Cash and cash equivalents decreased from $13.8 million on December 31, 2020 to $8.3 million on December 31, 2021. As of December 31, 2021, we had restricted cash of $12.2 million, all of which was classified as a current asset. These balances and the changes to the balances of cash and cash equivalents and restricted cash are further discussed in “Cash Flow” below and in “Note 3—Restricted Cash” in the “Notes to Consolidated Financial Statements.”

Contract receivables, net of allowance for expected credit losses, increased to $237.7 million on December 31, 2021 compared to $222.9 million on December 31, 2020, primarily due to the timing of our billings and collection of clients’ invoices. Contract receivables are a significant component of our working capital and generally increase due to revenue growth and may be favorably or unfavorably impacted by our collection efforts, including timing from new contract startups, and other short-term fluctuations related to the payment practices of our clients. Contract assets and contract liabilities represent revenue in excess of billings and billings in excess of revenue, respectively, both of which generally arise from revenue recognition timing and contractually stipulated billing schedules or billing complexities. As of December 31, 2021, contract assets and contract liabilities were $137.9 million and $39.7 million, respectively, compared to $143.4 million and $42.1 million, respectively, as of December 31, 2020. The changes to the balances of contract assets and contract liabilities are further discussed in “Note 11—Revenue Recognition” in the “Notes to Consolidated Financial Statements.”

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We evaluate our collections efforts using the days-sales-outstanding ratio (“DSO”), which we calculate by dividing total accounts receivable (contract receivables, net and contract assets, less contract liabilities) by revenue per day for the trailing three months period. We excluded from our calculation of DSO the accounts receivable and revenue from Creative Systems which we acquired on December 31, 2021. Days-sales-outstanding increased to 76 days for the quarter ended December 31, 2021 compared to 67 days for the same period in 2020.  Our DSO, excluding Puerto Rico disaster relief and rebuilding efforts, was 69 days for the quarter ended December 31, 2021, compared to 60 days for the quarter ended December 31, 2020. Our DSO was lower in 2020 compared to 2021 primarily due to significant collection efforts of our disaster relief and rebuilding contracts as well as accelerated collections related to media buys in 2020.

Prepaid expenses and other assets increased to $42.4 million at December 31, 2021 from $25.5 million at December 31, 2020.  The increase is due primarily to reimbursable lease incentives of $23.0 million related to our new corporate headquarters for leasehold improvements expected to be completed as we transition from our current corporate headquarters by the end of 2022 that offset a decrease in prepaid expenses in 2021 compared to the prior year.

Goodwill and other intangible assets, as discussed in “Note 6—Goodwill and Other Intangible Assets” and “Note 16 – Business Combinations” in the “Notes to Consolidated Financial Statements”, increased to $1,046.8 million and $79.6 million, respectively, at December 31, 2021 from $909.9 million and $59.9 million, respectively at December 31, 2020.  The increase is due primarily to the addition of $11.2 million and $126.1 million of goodwill related to the acquisitions of ESAC and Creative Systems, respectively, in 2021, and the impact of foreign currency translation of $0.5 million. The acquisitions of ESAC and Creative Systems also added $3.4 million and $28.9 million to other intangible assets, and the increase was offset by amortization of existing intangibles during 2021.  The balance of other intangibles were mainly related to customer relationships.

Operating lease - right-of-use assets increased to $177.4 million at December 31, 2021 from $127.1 million at December 31, 2020 and operating lease liability, both current and long-term, increased to $226.7 million at December 31, 2021 from $139.0 million at December 31, 2020, primarily due to us taking possession of our new corporate headquarters during the fourth quarter of 2021. As previously mentioned, we plan to complete the transition to our new corporate headquarters by the end of 2022.  Additionally, during 2021 we reviewed our operating lease facilities and either completely or partially discontinued usage of six offices. As a result, we incurred impairment charges on the rights-of-use asset of $7.9 million, other lease related costs of $1.5 million, and loss on disposal of property and equipment of $0.3 million.

Long-term debt increased to $421.6 million, net of unamortized debt issuance costs, at December 31, 2021 from $313.2 million at December 31, 2020, primarily due to financing of our acquisitions of ESAC and Creative Systems that occurred during the fourth quarter of 2021, offset by net repayments of the borrowings during the year. For the years ended December 31, 2021 and 2020, the average debt balance on our Credit Facility was $335.5 million and $428.0 million, respectively, and the average interest rate, excluding any fees and unamortized debt issuance costs, for the year ended December 31, 2021 and 2020 was 1.6% and 2.3%, respectively. We generally utilize cash flow from operations as our primary source of funding and utilize our Credit Facility to fund any temporary fluctuations, such as increases in contract receivables, reductions in accounts payable and accrued expenses, purchases of treasury stock, payments of declared dividends, additional capital expenditures, and to meet funding requirements for new acquisitions.

Other long-term liabilities as of December 31, 2021 was $24.1 million as compared to $40.1 million as of December 31, 2020. The decrease of $16.0 million was primarily due to the deferred employer Social Security tax liabilities of $10.5 million and the $1.2 million related to the prior acquisition being included in accrued expenses and other current liabilities at December 31, 2021, in addition to a reduction in the long-term portion of the fair value of the hedges by approximately $6.3 million compared to December 31, 2020.

The decrease in accumulated other comprehensive loss of $3.1 million, net of taxes, was driven by unrealized gains of $5.2 million in the fair value of the interest rate hedging instruments, offset by $0.5 million in prior unrealized gains reclassified to income related to hedging instruments previously sold and $1.5 million unrealized loss from the change in the value of certain foreign currencies relative to the U.S. dollar (primarily the British Pound, Euro and Canadian dollar.) See “Note 14—Accumulated Other Comprehensive Loss” in the “Notes to Consolidated Financial Statements.”

We have explored various options of mitigating the risk associated with potential fluctuations in the foreign currencies in which we conduct transactions. We currently have hedges in an amount proportionate to work anticipated to be performed under certain contracts in Europe. We recognize changes in the fair-value of the hedges

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in our results of operations. We may increase the number, size and scope of our hedges as we analyze options for mitigating our foreign exchange and interest rate risk. The current impact of the foreign currency hedges to the consolidated financial statements is immaterial.

Share Repurchase Program. The objective of our share repurchase program has been to offset dilution resulting from employee stock compensation. Under the program, purchases could be made from time to time at prevailing market prices in open market purchases or in privately negotiated transactions pursuant to Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and in accordance with applicable insider trading and other securities laws and regulations. The timing and extent to which we repurchase our shares will depend upon market conditions and other corporate considerations, as may be considered in our sole discretion. The purchases will be funded from existing cash balances and/or borrowings, and the repurchased shares will be held in treasury and used for general corporate purposes. The Credit Facility permits share repurchases, provided the Company’s Leverage Ratio, prior to and after giving effect to such repurchases, is not greater than 3.50 to 1.00.

In September 2017 the board of directors approved a share repurchase program that authorizes share repurchases in the aggregate up to $100.0 million.  In November 2021, the board of directors approved an increase to the share repurchase program to a new limit of $200.0 million, inclusive of the prior limit. During the fourth quarter of 2020, the board of directors approved a repurchase plan, as part of the normal approval process, which commenced on January 11, 2021 and ended on April 14, 2021 with total repurchases of 173,000 shares at an average price of $85.21 per share. During the fourth quarter of 2021, the board of directors approved a repurchase plan under the repurchase program to repurchase a maximum of 165,000 shares or a total of $20.0 million, whichever is reached first.  The plan commenced on December 20, 2021 and ends no later than June 30, 2022.  Under this plan, we repurchased 24,800 shares at an average price of $100.85 per share between the commencement date and December 31, 2021. For the year ended December 31, 2021, we repurchased a total of 197,800 shares under the share repurchase program at an average price of $87.17 per share. As of December 31, 2021, $128.8 million remained available for share repurchases under the share repurchase program.

Dividends.  Cash dividends declared in 2021 were as follows:

Cash Flows. We consider cash on deposit and all highly liquid investments with original maturities of three months or less when purchased to be cash and cash equivalents. The following table sets forth our sources and uses of cash for the following years.

Our operating cash flows are primarily affected by the overall profitability of our contracts, our ability to invoice and collect from our clients in a timely manner, and the timing of vendor and subcontractor payments in accordance with negotiated payment terms. We bill most of our clients on a monthly basis after services are rendered.

Operating activities provided $110.2 million in cash for the year ended December 31, 2021 compared to $173.1 million for the year ended December 31, 2020. The decrease of $62.9 million for the year ended December 31, 2021 compared to the 2020 was primarily due to $50.0 million of unexpected commercial client prepayments related to media placement in 2020 which were paid in early 2021, higher billings and lower collections of our

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contract receivables, increases to income tax receivable, and payment of previously deferred employer’s Social Security tax offset by increases to net income, inclusive of adjustments for non-cash expenses, lower prepaid expenses and other assets, and lower net use of cash for our payables, expenses, and vendor payments.

Investing activities used cash of $194.5 million for the year ended December 31, 2021, compared to $270.9 million for the year ended December 31, 2020. Our cash flows used in investing activities consists primarily of capital expenditures and acquisitions. During the year ended December 31, 2021, we used $174.5 million for payments to acquire ESAC and Creative Systems, net of cash acquired.  Cash used for capital expenditures totaled $19.9 million for the year ended December 31, 2021. For the year ended December 31, 2020, we used $253.3 million for acquisitions, net of cash acquired, for ITG and Eco-Tech, and $17.7 million for capital expenditures.

Financing activities consists primarily of debt and equity transactions and provided cash of $23.2 million for the year ended December 31, 2021 compared to $170.0 million for the same period in 2020. For the year ended 2021, cash flows provided by financing activities were primarily due to net borrowings on our Credit Facility of $107.8 million and proceeds from exercise of options of $2.8 million, offset by net payments of restricted contract funds of $55.8 million, share repurchases under our share repurchase plan and shares purchased from employees to pay required withholding taxes related to settlement of restricted stock units of $20.0 million, dividend payments of $10.6 million, and payments on business acquisition liabilities of $1.0 million. For the year ended 2020, cash flows provided by financing activities were primarily due to the net advance from our Credit Facility of $150.3 million and net receipt and payments of restricted contract funds of $65.6 million, offset by shares purchased from employees to pay required withholding taxes related to settlement of restricted stock units of $29.7 million, dividend payments of $10.6 million, payments of debt issuance costs of $2.1 million, payments on business acquisition liabilities of $1.9 million, and payments on capital expenditure obligations of $1.7 million.

OFF-BALANCE SHEET ARRANGEMENTS

We had nine outstanding letters of credit provided for under our Credit Facility with a total value of $3.3 million, primarily related to deposits to support our facility leases.