EXPONENT INC (EXPO) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This section of this Annual Report on form 10-K generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 and year-to-year comparisons between 2020 and 2019 that are not included in this Annual Report 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 the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, 2021.

OVERVIEW

Exponent is an engineering and scientific consulting firm providing solutions to complex problems. Exponent's interdisciplinary organization of scientists, physicians, engineers, and business consultants draws from more than 90 technical disciplines to solve the most pressing and complicated challenges facing stakeholders today. The firm leverages over 50 years of experience in analyzing accidents and failures to advise clients as they innovate their technologically complex products and processes, ensure the safety and health of their users, and address the challenges of sustainability.

CRITICAL ACCOUNTING ESTIMATES

In preparing our consolidated financial statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income and net income, as well as on the value of certain assets and liabilities on our consolidated balance sheet. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. On a regular basis we evaluate our assumptions, judgments and estimates and make changes accordingly. We believe that the assumptions, judgments and estimates involved in accounting for revenue recognition and estimating the allowance for contract losses and doubtful accounts have a potential impact on our consolidated financial statements, so we consider these to be our critical accounting policies. We discuss below the assumptions, judgments and estimates associated with these policies. Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results. For further information on our critical accounting policies, see Note 1 of our Notes to Consolidated Financial Statements

Revenue recognition. We derive our revenues primarily from professional fees earned on consulting engagements, fees earned for the use of our equipment and facilities, as well as reimbursements for outside direct expenses associated with the services that are billed to our clients.

Substantially all of our engagements are service contracts performed under time and material or fixed-price billing arrangements. For time and material and fixed-price service projects, revenue is generally recognized as the services are performed. For substantially all of our fixed-price service engagements, we recognize revenue based on the relationship of incurred labor hours at standard rates to our estimate of the total labor hours at standard rates we expect to incur over the term of the contract. Our estimate of total labor hours we expect to incur over the term of the contract is based on the nature of the project and our past experience on similar projects. We believe this methodology achieves a reliable measure of the revenue from the consulting services we provide to our customers under fixed-price contracts.

Management judgments and estimates must be made and used in connection with the revenues recognized in any accounting period. These judgments and estimates include an assessment of the estimate as to the total effort required to complete fixed-price projects.

Estimating the allowance for contract losses and doubtful accounts. We make estimates of our ability to collect accounts receivable and our unbilled but recognized work-in-process. In circumstances where we are aware of a specific customer’s inability to meet its financial obligations to us or for disputes with customers that affect our ability to fully collect our accounts receivable and unbilled work-in-process, we record a specific allowance to reduce the net recognized receivable to the amount we reasonably believe will be collected. For all other customers we recognize allowances for contract losses and doubtful accounts taking into consideration factors such as historical write-offs, customer concentration, customer creditworthiness, current and forecasts of future economic conditions, and aging of amounts due.

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The following table sets forth, for the periods indicated, the percentage of revenues of certain items in our consolidated statements of income and the percentage increase (decrease) in the dollar amount of such items year to year:

EXECUTIVE SUMMARY

Revenues for 2021 increased 17% and revenues before reimbursements increased 15% as compared to the prior year. The increase in revenues before reimbursements was due to an increase in billable hours and an increase in billing rates. Our multi-disciplinary team of engineers and scientists continues to deliver unique and innovative solutions as we broaden our client base and deepen our relationships. Among our proactive services, demand for human factors and machine learning studies was strong throughout 2021 and is expected to continue as clients seek data to improve user experience and advance product performance. At the same time, within our reactive services, litigation related work continues to recover as courts further adapt operating procedures to the COVID-19 environment. Over the last year we further evolved our capabilities, ensuring we can support our clients as they seek to deliver safer, healthier, and more sustainable products and services.

Growth during 2021 was broad-based, with continued strong demand for our services across the utilities, consumer electronics, consumer products, life sciences and automotive sectors. Growth was also driven by our proactive safety-related work evaluating the impacts of chemicals on human health and the environment.

Society is raising the bar for safety, health, sustainability and reliability, and clients are increasingly seeking our interdisciplinary proactive solutions. As our suite of offerings and key markets expands, so does the demand for our multidisciplinary services. At the onset of the COVID-19 pandemic, we acted swiftly in the face of uncertainty to align our business to protect profitability, but as demand for our services increased, we accelerated our recruiting efforts. While the job market for engineering and scientific talent remains highly competitive, we persist in our ability to attract world-class talent.

Net income was $101,202,000 during 2021 as compared to $82,552,000 during 2020. Diluted earnings per share increased to $1.90 for 2021 as compared to $1.55 for 2020. Net income and diluted earnings per share for 2021 and 2020 benefited from the excess tax benefit associated with stock-based awards. The excess tax benefit associated with stock-based awards decreased to $10,009,000 during 2021 as compared to $12,258,000 during 2020. The decrease in the excess tax benefit was due to a smaller increase in value of our common stock between the grant date and the release date for the restricted stock units released during 2021 as compared to 2020.

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We remain focused on selectively adding top talent and developing the skills necessary to expand upon our market position, providing clients with in-depth scientific research and analysis to determine what happened and how to prevent failures or exposures in the future. We also remain focused on capitalizing on emerging growth areas, managing other operating expenses, generating cash from operations, maintaining a strong balance sheet and undertaking activities such as share repurchases and dividends to enhance shareholder value.

OVERVIEW OF THE YEAR ENDED DECEMBER 31, 2021

Our revenues consist of professional fees earned on consulting engagements, fees for use of our equipment and facilities, and reimbursements for outside direct expenses associated with the services performed that are billed to our clients.

We operate on a 52-53 week fiscal year with each year ending on the Friday closest to December 31st. Fiscal period 2021 included 52 weeks of activity and ended on December 31, 2021. Fiscal period 2020 inluded 52 weeks of activity and ended on January 1, 2021. Fiscal period 2019 included 53 weeks of activity and ended on January 3, 2020. Fiscal period 2022 is 52 weeks and will end on December 30, 2022.

During 2021, billable hours increased 10% to 1,405,000 as compared to 1,273,000 during 2020. Our utilization increased to 75% for 2021 as compared to 67% for 2020. Technical full-time equivalent employees decreased 1% to 900 for 2021 as compared to 912 for 2020. We continue to selectively hire key talent to expand our capabilities.

FISCAL YEARS ENDED DECEMBER 31, 2021 AND JANUARY 1, 2021

Revenues

The increase in revenues for our Engineering and Other Scientific segment was due to an increase in billable hours and an increase in billing rates. During 2021, billable hours for this segment increased by 13% to 1,101,000 as compared to 976,000 during 2020. Utilization for this segment increased to 77% for 2021 as compared to 67% for 2020 due to increased workflow and a decrease in technical full-time equivalent employees. Growth during 2021 was broad-based, with continued strong demand for our services across the utilities, consumer electronics, consumer products, life sciences, and automotive sectors. In addition to the steady increase in litigation support and human participant studies, our multidisciplinary battery team continued to see demand for its solutions in electric vehicles and energy storage. Our work in international arbitrations and integrity management advisory services continued at strong levels. Technical full-time equivalent employees in this segment decreased 2% to 688 during 2021 as compared to 704 for 2020. The decrease in technical full-time equivalent employees was due in part to the divestiture of our German subsidiary in April of 2020.

The increase in revenues from our Environmental and Health segment was due to an increase in billable hours and an increase in billing rates. During 2021, billable hours for this segment increased by 2% to 304,000 as compared to 297,000 during 2020. Growth in this segment, which saw less impact from business restrictions in 2020, was primarily driven by our proactive safety-related work evaluating the impacts on chemicals on human health and the environment. Utilization for this segment was 69% for both 2021 and 2020. Technical full-time equivalents increased 2% to 212 during 2021 as compared to 208 for 2020 due to our recruiting and retention efforts.

Revenues are primarily derived from services provided in response to client requests or events that occur without notice and engagements are generally terminable or subject to postponement or delay at any time by our clients. As a result, backlog at any particular time is small in relation to our quarterly or annual revenues and is not a reliable indicator of revenues for any future periods.

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Compensation and Related Expenses

The increase in compensation and related expenses during 2021 was due to an increase in bonus expense, a change in the value of assets associated with our deferred compensation plan, an increase in wages, and an increase in fringe benefits. During 2021, bonus expense increased by $15,186,000 due to a corresponding increase in the bonus pool, which is 33% of income before income taxes, interest income, bonus expense, and stock-based compensation. During 2021, deferred compensation expense increased $6,702,000 with a corresponding increase to other income, net, as compared to the prior year due to the change in value of assets associated with our deferred compensation plan. This increase consisted of an increase in the value of the plan assets of $14,730,000 during 2021 as compared to an increase in the value of the plan assets of $8,028,000 during 2020. Wages increased $3,280,000 during 2021 due to the impact of our annual salary increase. Fringe benefits increased $2,708,000 during 2021 due to an employee retention credit that we claimed under the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) for $2,230,000 during 2020. There was no CARES Act credit claimed during 2021. We expect our compensation expense, excluding the change in value of deferred compensation plan assets, to increase as we selectively add new talent and adjust compensation to market conditions.

Other Operating Expenses

Other operating expenses include facilities-related costs, technical materials, computer-related expenses and depreciation and amortization of property, equipment and leasehold improvements. The increase in other operating expenses was primarily due to an increase in information technology related expenses partially offset by a decrease in depreciation expense and a decrease in occupancy expense. We expect other operating expenses to grow as we selectively add new talent, make additional investments in our corporate infrastructure, and transition our workforce back to our offices as COVID-19 pandemic-related business restrictions are lifted.

Reimbursable Expenses

The amount of reimbursable expenses will vary from year to year depending on the nature of our projects. The increase in reimbursable expenses during 2021 was primarily due an increase in project-related travel and other project-related expenses as COVID-19 pandemic-related business and travel restrictions eased.

General and Administrative Expenses

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The increase in general and administrative expenses during 2021 was primarily due to an increase in outside consulting services of $425,000, an increase in liability insurance premiums of $366,000, an increase in legal fees of $349,000, an increase in charitable contributions of $201,000, an increase in employee relocation of $190,000, an increase in employee relations of $173,000, an increase marketing and business development expenses of $165,000, and several other individually insignificant increases. The increase in outside consulting during 2021 was due to the completion of several projects associated with investments in our corporate infrastructure. There was a lower level of activity during 2020 in outside consulting due to the COVID-19 pandemic. The increase in liability insurance premiums was due to pricing increases associated with our annual insurance renewal. The increase in legal fees was primarily due to compliance costs associated with our international operations. The increase in charitable contributions was due to a gift of $250,000 to the Georgia Tech Foundation for the newly established Exponent Dean’s Scholarship Endowment in the College of Engineering. The increases in employee relocation, employee relations, and marketing and business development expenses were due to an increase in human capital and business development activities. We expect general and administrative expenses to increase as we selectively add new talent, expand our business development efforts, and pursue staff development initiatives.

Operating Income

The increase in operating income for our Engineering and Other Scientific segment during 2021 as compared to 2020 was due to an increase in revenues driven by an increase in the utilization. Utilization for this segment increased to 77% for 2021 as compared to 67% during 2020 due to increased workflow and a 2% decrease in technical full-time equivalent employees. Growth during 2021 was broad-based, with continued strong demand for our services across the utilities, consumer electronics, consumer products, life sciences, and automotive sectors. In addition to the steady increase in litigation support and human participant studies, our multidisciplinary battery team continued to see demand for its solutions in electric vehicles and energy storage. Our work in international arbitrations and integrity management advisory services continued at strong levels.

The increase in operating income for our Environmental and Health segment during 2021 as compared to 2020 was due to an increase in revenues. The increase in revenues was due to an increase in billable hours and an increase in billing rates. Growth in this segment, which saw less impact from business restrictions in 2020, was primarily driven by our proactive safety-related work evaluating the impacts on chemicals on human health and the environment.

Certain operating expenses are excluded from the Company’s measure of segment operating income. These expenses include the costs associated with our human resources, finance, information technology, and business development groups; the deferred compensation expense/benefit due to the change in value of assets associated with our deferred compensation plan; stock-based compensation associated with restricted stock unit and stock option awards; and the change in our allowance for contract losses and doubtful accounts.

The increase in corporate operating expenses during 2021 as compared to 2020 was primarily due to an increase in deferred compensation expense. During 2021, deferred compensation expense increased $6,702,000 with a corresponding increase to other income, net, as compared to the prior year due to the change in value of assets associated with our deferred compensation plan. This increase consisted of an increase in the value of the plan assets of $14,730,000 during 2021 as compared to an increase in the value of the plan assets of $8,028,000 during 2020. During 2020 we claimed an employee retention credit for $2,230,000 under the CARES Act. This credit was excluded from fringe benefits in our measure of segment operating income. There was no CARES Act credit claimed during 2021. Corporate operating expenses also increased due to increases in costs associated with our human resources, finance, information technology, and business development groups as we continue to make investments in these areas to support our growth.

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Other Income

Other income consists primarily of interest income earned on available cash, cash equivalents and short-term investments, changes in the value of assets associated with our deferred compensation plan and rental income from leasing excess space in our Silicon Valley facility. The increase in other income was primarily due to the change in value of assets associated with our deferred compensation plan partially offset by a decrease in interest income, a change in the realized gain/loss on foreign exchange, and a decrease in rental income. During 2021, other income, net, increased $6,702,000 with a corresponding increase to deferred compensation expense as compared to the prior year due to the change in value of assets associated with our deferred compensation plan. This increase consisted of an increase in the value of the plan assets of $14,730,000 during 2021 as compared to an increase in the value of the plan assets of $8,028,000 during 2020. During 2021 interest income decreased by $1,639,000 due to lower interest rates for our cash equivalents and short-term investments. During 2021, other income, net, decreased by $1,109,000 as compared to 2020 due to a change in the realized gain/loss on foreign exchange. This decrease consisted of a realized loss on foreign exchange of $517,000 during 2021 as compared to a realized gain on foreign exchange of $592,000 during 2020. During 2021, rental income decreased $692,000 as compared to 2020 due to an increase in our vacancy rate.

Income Taxes

The increase in our effective tax rate was due to a decrease in the excess tax benefit associated with stock-based awards. The excess tax benefit associated with stock-based awards decreased to $10,009,000 during 2021 as compared to $12,258,000 during 2020. The decrease in the excess tax benefit was due to a smaller increase in the value of our common stock between the grant date and the release date for the restricted stock units released during 2021 as compared to 2020. Excluding the impact of the excess tax benefit, the effective tax rate would have been 27.5% for both 2021 and 2020.

LIQUIDITY AND CAPITAL RESOURCES

We financed our business in 2021 through available cash and cash flows from operating activities. We invest our excess cash in cash equivalents and short-term investments. As of December 31, 2021, our cash and cash equivalents were $297,687,000 as compared to $242,526,000 at January 1, 2021. We believe our existing balances of cash, cash equivalents and short-term investments will be sufficient to satisfy our working capital needs, capital expenditures, outstanding commitments, stock repurchases, dividends and other liquidity requirements over at least the next 12 months.

Generally, our net cash provided by operating activities is used to fund our day-to-day operating activities. First quarter operating cash requirements are generally higher due to payment of our annual bonuses accrued during the prior year.

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Our largest source of operating cash flows is cash collections from our clients. Our primary uses of cash from operating activities are for employee-related expenditures, leased facilities, taxes, and general operating expenses.

Net cash provided by operating activities was $124.6 million for 2021 as compared to $103.3 million in 2020.

During 2021 and 2020, net cash provided by investing activities was primarily related to the purchase and maturity of short-term investments and capital expenditures.

The decrease in net cash used in financing activities during 2021 as compared to 2020 was due to a decrease in repurchases of our common stock and a decrease in the proceeds from the exercise of stock-based payment awards partially offset by an increase in our quarterly dividend payment.

We lease office, laboratory, and storage space in 13 states and the District of Columbia, as well as in China, Hong Kong, Singapore, Switzerland, and the United Kingdom under non-cancellable operating lease arrangements that expire at various dates through 2028. As of December 31, 2021, the value of our obligations under operating leases was $16,763,000. See Note 12 of our Notes to Consolidated Financial Statements for additional information regarding our lease obligations. The value of our non-cancellable unconditional purchase obligations was not material at December 31, 2021.

We expect to continue our investing activities, including capital expenditures. Furthermore, cash reserves may be used to repurchase common stock under our stock repurchase programs, pay dividends, procure facilities and equipment or strategically acquire professional service firms that are complementary to our business.

We maintain nonqualified deferred compensation plans for the benefit of a select group of highly compensated employees. Vested amounts due under the plans of $100,999,000 were recorded as a long-term liability on our consolidated balance sheet at December 31, 2021. Vested amounts due under the plans of $9,380,000 were recorded as a current liability on our consolidated balance sheet at December 31, 2021. Company assets that are earmarked to pay benefits under the plans are held in a rabbi trust and are subject to the claims of our creditors. As of December 31, 2021, invested amounts under the plans of $99,962,000 were recorded as a long-term asset on our consolidated balance sheet. As of December 31, 2021, invested amounts under the plans of $9,380,000 were recorded as a current asset on our consolidated balance sheet.

As permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that reduces our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

Non-GAAP Financial Measures

Regulation G, conditions for use of Non-Generally Accepted Accounting Principles (“Non-GAAP”) financial measures, and other SEC regulations define and prescribe the conditions for use of certain Non-GAAP financial information. Generally, a Non-GAAP financial measure is a numerical measure of a company's performance, financial position or cash flow that either excludes or includes amounts that are not normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP. We closely monitor two financial measures, EBITDA and EBITDAS, which meet the definition of Non-GAAP financial measures. We define EBITDA as net income before income taxes, interest income, depreciation and amortization. We define EBITDAS as EBITDA before stock-based compensation. We regard EBITDA and EBITDAS as useful measures of operating performance and cash flow to complement operating income, net income and other GAAP financial performance measures. Additionally, management believes that EBITDA and EBITDAS provide meaningful comparisons of past, present and future operating results. These measures are used to evaluate our financial results, develop budgets and determine employee compensation. These measures, however, should be considered in addition to, and not as a substitute or

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superior to, operating income, cash flows, or other measures of financial performance prepared in accordance with GAAP. A reconciliation of the Non-GAAP measures to the nearest comparable GAAP measure is set forth below.

The following table shows EBITDA as a percentage of revenues before reimbursements for 2021 and 2020:

The increase in EBITDA as a percentage of revenues before reimbursements during 2021 as compared to 2020 was primarily due to the 15% increase in revenues before reimbursements and slower growth in compensation and related expenses and other operating expenses. The increase in revenues before reimbursements was due to an increase in billable hours and an increase in billing rates. Our multi-disciplinary team of engineers and scientists continues to deliver unique and innovative solutions as we broaden our client base and deepen our relationships. Among our proactive services, demand for human factors and machine learning studies was strong throughout 2021 and is expected to continue as clients seek data to improve user experience and advance product performance. At the same time, within our reactive services, litigation related work continues to recover as courts further adapt operating procedures to the COVID-19 environment. Over the last year we further evolved our capabilities, ensuring we can support our clients as they seek to deliver safer, healthier, and more sustainable products and services. The slower growth in compensation and related expenses during 2021 was due to a decrease in technical full-time equivalent employees. Due to our recruiting efforts, hiring has picked up over the last several months despite the competitive market for engineering and scientific talent. As such we expect compensation and related expenses to increase. The slower growth in other operating expenses was primarily due to the continued business restrictions associated with the COVID-19 pandemic. We expect other operating expenses to increase as COVID-19 pandemic-related business restrictions are eased.

The following table is a reconciliation of EBITDA and EBITDAS to the most comparable GAAP measure, net income, for 2021 and 2020:

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