Cloudflare, Inc. Q1 FY2022 Earnings Call

Thank you all for joining us today for Cloudflare's First Quarter 2021 Earnings Call. We appreciate your patience. Jayson Noland, Head of Investor Relations, will now start the conference.

Thank you for joining us to discuss Cloudflare's financial results for the first quarter of 2022. With me on the call, we have Matthew Prince, Co-Founder and CEO; Michelle Zatlyn, Co-Founder, President and COO; and Thomas Seifert, CFO. By now, everyone should have access to our earnings announcement. This announcement, as well as our supplemental financial information, may be found on our Investor Relations website. As a reminder, we'll be making forward-looking statements during today's discussion, including, but not limited to, our customers, vendors and partners operations and future financial performance, anticipated product launches and the timing and market potential of those products, the company's anticipated future revenue, financial performance, operating performance, non-GAAP gross margin, non-GAAP net income or loss, non-GAAP net income or loss per share, shares outstanding, non-GAAP operating expenses, free cash flow, non-GAAP tax expense, dollar-based net retention rate, paying customers and large customers. These statements and other comments are not guarantees of future performance, but rather are subject to risks and uncertainty, some of which are beyond our control, including, but not limited to, the extent and duration of the impact of the COVID-19 pandemic and adverse conditions in the general domestic and global economic markets. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our filings with the Securities and Exchange Commission, as well as in today's earnings press release. Unless otherwise noted, all numbers we talk about today, other than revenue, will be on an adjusted non-GAAP basis. All current and prior period financials discussed are reflected under ASC 606. You may find a reconciliation of GAAP to non-GAAP financial measures in our earnings release on our Investor Relations website. For historical periods, a GAAP to non-GAAP reconciliation can be found in the supplemental financial information referenced a few moments ago. Before finishing up, I'd like to invite you to join us for our Investor Day next week on Thursday, May 12. It's being held in conjunction with our user conference, Cloudflare Connect, in New York City. This event will start at 9:00 a.m. Eastern and finish around 11:45, with a live webcast accessible from our Investor Relations website. Additionally, we will be participating in the Jefferies Software Conference in San Francisco on June 1. Now I'd like to turn the call over to Matthew.

Thank you, Jayson. We had an excellent quarter. In Q1, we reported revenue of $212 million, increasing 54% compared to last year. We set a quarterly record by adding over 14,000 new paying customers, which is a 10% increase from the previous quarter, raising our total paying customer base to over 154,000. We gained 121 new large customers, those contributing over $100,000 annually, marking a 53% rise year-over-year to a total of 1,537. Currently, 58% of our revenue is sourced from these large customers. Our largest customers are also growing; those spending over $500,000 yearly increased by 68% year-over-year, and those exceeding $1 million grew by 72%. We now have 12 customers and partners investing over $5 million each year with us. Despite this, we maintain a high level of diversification, with no single customer accounting for more than 5% of our revenue. Our strategy of land and expand is proving effective, as evidenced by our dollar-based net retention rate hitting a new peak of 127% in the quarter, up 400 basis points from last year. The introduction of new products and heightened interest in consolidating network services under a single reliable vendor have been crucial for our ongoing customer growth. We have always prioritized efficiency, and even during these inflationary times, we recorded a gross margin of 78.7% in the quarter, a 110 basis point increase year-over-year. This is consistently above our target range of 75% to 77%, allowing us to strategically target competitors' customers with bundled products that work seamlessly together, minimizing the number of vendors they need while delivering modern solutions and saving them money. This approach is especially attractive as competitors raise prices or struggle to deliver their legacy hardware. We completed our largest acquisition to date in the quarter by acquiring Area 1 Security for $162 million. We have stringent criteria for acquisitions, favoring internal development, but the technology and team at Area 1 are exceptional. Initially, we were customers of theirs. I remember reaching out to our Chief Security Officer to inquire about the absence of phishing reports after we implemented their solution, which typically generated daily reports in the double digits. It turned out that Area 1's remarkable email security technology was the reason for this change. If you're still encountering phishing messages in your inbox, encourage your IT team to contact us, as we now have an excellent solution. Over the years of being an Area 1 customer, we built a strong rapport with their team. At Cloudflare, we have a passion for technology and can discern genuine technology from unreliable options. The Area 1 team shares our enthusiasm, making collaboration enjoyable, and their technology is credible. We discussed a potential partnership, but it quickly became clear that integrating them into Cloudflare and our zero trust suite was the more sensible choice. To illustrate how well this has been received, we offered positions to the entire Area 1 team, and remarkably, 98% of them accepted, even in a competitive job market. I'm still hopeful for the one team member who hasn't joined yet, as it indicates a strong technological and cultural fit between our companies. Email is the primary vehicle for network threats, an area where no leading zero trust vendor has truly delivered integrated email security, representing a significant industry oversight. As competitors scramble to enhance their offerings in response to this gap, it's the best indication that Cloudflare's zero trust solution is gaining traction in the market and capturing market share, regardless of competitors' claims. We continue to have the best team and technology in the sector. Let's highlight some customer successes from the quarter, starting with Area 1. In the latter half of Q1, our sales teams collaborated closely, resulting in several wins from existing Cloudflare clients adding Area 1, as well as accelerated deals from Area 1's pipeline following our acquisition announcement. Practitioners trust Cloudflare, knowing that any technology we acquire is effective and scalable. New onboarded clients for Area 1 included a major Asian airline, a significant U.S. investment bank, and a Fortune 1000 trucking firm. To delve into the trucking company's story, they were already a Cloudflare client testing various email security vendors. During these trials, Area 1 outperformed every competitor, catching twice as many phishing emails, making it an easy choice for them once they learned it was part of Cloudflare. They finalized a two-year deal for 7,500 seats at $385,000. Expect more similar stories in the future. We continue to excel with our other zero trust offerings, as evidenced by a deal with a Midwestern U.S. state for 75,000 seats over three years at $5.1 million. They were transitioning from legacy hardware to a cloud solution when they approached us. This competitive deal favored Cloudflare for its integrated approach, providing a unified overview with cohesive policies and threat intelligence. They also valued our performance and the network presence within their state's borders. This was a collaborative sale with a significant systems integrator, a trend we anticipate will continue in larger zero trust transactions. We are confident that our product implementations allow for substantial partner ecosystem support. A major Indian media outlet selected Cloudflare over Zscaler and Palo Alto Networks for their zero trust network, securing a $150,000 agreement for 5,000 seats, appreciating the seamless integration of our solutions compared to the competition. We are increasingly competing against Zscaler and Palo Alto Networks, and our win rates are promising. A European Fortune 500 automotive company adopted our zero trust approach to manage their global fleet of over 10 million vehicles, signing a $320,000 annual contract. We observe a growing trend in IoT zero trust applications and see significant possibilities for expansion with this client. In terms of expansion, a Fortune 500 software company enhanced their engagement with us, increasing their annual run rate to $15 million. The new agreement extended our collaboration to another IT division. They consistently communicate that we are the sole vendor they trust for critical services. In the trust theme, a large social network signed a $3 million, five-year contract, utilizing our global network to validate the security of a messaging product. Their authentication application runs on Workers, our serverless computing platform, which can accommodate their massive scale, showcasing effortless scalability. Sticking with Workers, a large Australian software company adopted it for a collaboration tool, signing a $145,000 contract, using Workers' durable object feature for global real-time synchronization. We've seen natural expansion with Workers, as adept software teams recognize its potential to deploy code directly into Internet infrastructure. We anticipate this client will explore more projects with Workers following their initial success. A Fortune 500 healthcare company entered a $1.2 million, three-year agreement for a standard network security upgrade replacing legacy hardware. Interestingly, the IT team transitioned from another large financial company that utilized our services before. As they switched jobs, they brought Cloudflare to their new firm. We expect more instances of this as professionals who have thrived in their previous roles with us progress in their careers. A Fortune 500 financial services company fully committed to Cloudflare, seeing us as their future, signing a $1.5 million, three-year deal following a four-month sales cycle. They replaced multiple legacy vendors and consolidated various network services with us, realizing they wanted a cohesive network rather than piecing together different products. They recognized they could achieve a highly integrated network with features that operate together smoothly. We foresee continued growth in our contracts as they fully adopt the Cloudflare system. Lastly, a Fortune 1000 gaming company signed a $3.3 million, three-year agreement after experiencing security issues with AWS that couldn't prevent attacks. After challenges keeping their application functioning, AWS's team suggested they switch to Cloudflare, which they did. In closing, I want to remark on the situation in Russia and Ukraine. I mentioned the region during our last earnings call, and several of you expressed concern, but it turned out to be timely. Our global network at Cloudflare serves as an early warning for online activity. In the month leading up to the Russian invasion, we observed cyber probing and other indicators reminiscent of prior conflicts in Georgia and Crimea. Concerned, we informed Western governments and offered our services to critical infrastructure providers and Ukrainian institutions well before the invasion. Many organizations accepted our offer of protection. One narrative of the conflict has been the relative scarcity of cyberattacks, which is not entirely accurate. While there have been attacks, the successful ones have been few, and I take pride in Cloudflare's role in this. In Russia, Belarus, and Russian-occupied Ukraine, we terminated all accounts linked to sanctioned individuals and instituted extra verification for new customers. This region contributes less than 1% to our revenue, so we don't anticipate significant financial repercussions, but we are prudently reserving for unfavorable scenarios, similar to our approach at the onset of COVID. An unexpected occurrence this quarter was our 1.1.1.1 app reaching the top spot in Russian app stores. We designed this app for consumers at no cost as the largest test bed for a crucial element of our zero trust solution. In an increasingly controlled online environment in Russia, app users seeking access to Western media opted to download it. We won't profit from this, and you might wonder why I'm sharing it during our earnings call. It's because acting ethically and being present for those in need online has always been central to Cloudflare's mission and has proven to be beneficial for us in the long run. This reinforces my passion for my work. Successfully navigating the hostile network landscape in Russia enhances our mobile app for enterprise zero trust clients, and maintaining Ukrainian critical infrastructure supports our ability to withstand extensive nation-state-sponsored attacks for our largest government and financial services customers. Informing governments about impending events showcases the power and unique insights from our global network. Trust is at the core of our business, and in Q1, it flourished across many quarters. Even amidst what may be the industry's most challenging quarter since Q1 2020, trust is the key reason we're witnessing record customer growth. This is evident in the 133,000 job applications we've received and a decrease in employee turnover, while many others face hiring challenges. We remain integral in discussions about the future regulation of the Internet alongside leading tech companies. We will be present wherever the Internet needs us, including in Ukraine, Russia, and beyond. As we continue this journey, we are planting the groundwork for our future aspirations—not just as a typical SaaS company, but as a notable, reliable technology company that will shape the Internet's future for years to come. Now, I'll hand it over to Thomas to delve into our strong performance numbers.

Thank you, Matthew, and thank you to everyone for joining us. We continued the momentum from the fourth quarter and delivered a strong Q1, exceeding the high end of our revenue guidance with strength in multiple areas of the business. Turning to revenue. Total revenue for the first quarter increased 54% year-over-year to $212.2 million. The growth in revenue was driven by strong adoption of our product portfolio and continued traction with our enterprise customer base. From a geographic perspective, in Q1, we saw continued strength in both the U.S. and internationally. The U.S. represented 53% of revenue and increased 56% year-over-year. EMEA represented 26% of revenue and increased 57% year-over-year. APAC represented 14% of revenue and increased 31% year-over-year. We are pleased to see growth continue to accelerate in APAC and see EMEA repeat as our highest growth geography this quarter. Turning to customer metrics. We exited the quarter with 154,109 paying customers, representing an increase of 29% year-over-year. We ended the year with 1,537 large customers, representing an increase of 63% year-over-year or an addition of 121 large customers in the quarter. We were pleased to see large customer revenue contribution increase again sequentially. Significant expansion from our large customers contributed to a record dollar-based net retention rate of 127%, representing an increase of 200 basis points sequentially. We continue to see broad-based strength across our enterprise go-to-market efforts, which we look forward to providing additional insights during our Investor Day next week. Moving to gross margin. First quarter gross margin was 78.7%, consistent with last quarter. Network CapEx represented 9% of revenue in the first quarter. Going forward, we expect to see some level of quarter-to-quarter variability given strategic purchase decisions and continue to expect network CapEx to be 12% to 14% of revenue for fiscal 2022. Turning to operating expenses. First quarter operating expenses as a percentage of revenue decreased 2% sequentially and decreased 7% year-over-year to 76%. We had another strong hiring quarter where we saw our total number of employees increase 42% year-over-year, bringing our total number of employees to approximately 2,750 at the end of the quarter. Sales and marketing expenses were $89.7 million for the quarter. Sales and marketing as a percentage of revenue decreased 2% sequentially and decreased to 42% from 46% in the same quarter last year. Research and development expenses were $40.3 million in the quarter. R&D as a percentage of revenue stayed flat sequentially and decreased to 19% from 21% in the same quarter last year. G&A expenses were $32 million for the quarter. G&A as a percentage of revenue increased 1% sequentially and decreased to 15% from 17% in the same quarter last year. We saw continued operating leverage strength in the first quarter with operating margin improving 770 basis points year-over-year. Operating income was $4.9 million compared to an operating loss of $7.5 million in the same period last year. Q1 was our third consecutive quarter of achieving operating profit. And as a reminder, we intend to grow our operating expenses in line with revenue, staying here or at breakeven and reinvesting excess profitability back into the business to address the enormous opportunity in front of us. Turning to net income and the balance sheet. Our net income in the quarter was $3.5 million or net income per share of $0.01. Tax expense for the first quarter was $1.7 million. We ended the first quarter with $1.7 billion in cash, cash equivalents, and available-for-sale securities. Free cash flow was negative $64.4 million or 30% of revenue compared to negative $2.2 million or 2% of revenue in the same period last year. Operating cash flow was negative $35.5 million in the first quarter or 70% of revenue, compared to $23.5 million or 17% of revenue in the same period last year. The decrease in cash flow was primarily related to a unique withholding tax payment of approximately $30 million. As mentioned last quarter, we expected to see some cash flow variability in the first half of 2022, but we continue to expect to return to positive free cash flow in the second half of this year. Remaining performance obligations, or RPO, came in at $688 million, representing an increase of 10% sequentially and 57% year-over-year. Current RPO was 76% of total RPO. Turning to guidance. As Matthew mentioned, we closed the Area 1 acquisition on April 1, which is expected to contribute less than 1% to revenue, and the dilutive impact on profitability is reflected in guidance in both the second quarter and full year. Additionally, in the first quarter, we also ended all relationships with users tied to sanctioned parties in Russia, which represented less than a 1% impact on revenue. For the second quarter, we expect revenue in the range of $126.5 million to $227.5 million, representing an increase of 49% year-over-year. We expect an operating loss, including Area 1, in the range of $2 million to $1 million. We expect a net loss per share of $0.01 to breakeven. For modeling purposes, please note that if we report positive net income in the second quarter, we expect our share count to be 344 million fully diluted shares for the 325 million basic shares if we report a net loss. We expect a tax expense of $1.8 million. For the full year 2022, we expect revenue in the range of $955 million to $959 million, representing an increase of 45% to 46% year-over-year. We expect operating income for the full year in the range of $10 million to $14 million, and we expect net income per share over that period in the range of $0.03 to $0.04, assuming approximately 345 million common shares outstanding. We expect a tax expense of $7.7 million. In closing, it was another very strong quarter. I once again want to thank our employees for delivering these great results and for their continued dedication. We look forward to hosting our second Investor Day next Thursday, where we'll do a deeper dive on our product portfolio and recent acquisitions, as well as updates on our financial progress and market opportunity. And with that, I'd like to open it up for questions. Operator, please poll for questions.

Your first question is from Matt Hedberg with RBC Capital Markets.

It's Dan Berger for Matt Hedberg. Say, dollar-based net retention continues to track well, the 127% was really nice to see, obviously having success with large customer expansion. Maybe a little more, if you could, on what gets customers to buy into the broader set of the platform? And what really gets those enterprise customers to the next level of usage?

Sure. I think that what we have seen is that once the customer is on our network, we can see traffic across their systems typically and make intelligent recommendations on what additional products. So I'll give you a specific example. We have an incredible bot management product that is good at stopping malicious automated traffic on a customer's site. One of the things we do is even before someone is using the bot management product, we can look at their traffic patterns, see how many bots they have and then generate a report for them that says, 'You have a bot problem. Here's what we see. Would you like us to help you with it?' I think that those sorts of intelligent recommendations have been very effective in getting customers to adopt additional products on our platform. Additionally, we will bundle together our services into much broader licenses, as we've talked about in previous earnings calls. Companies that buy into our total infrastructure commit to a certain spend with us and then they can continuously add additional products, which we true up on an annual basis. I think we are unique in that we have such a broad set of products, where once you're using our service, we can start making intelligent recommendations, solving many problems for customers, making those sorts of site-wide licenses make sense. I believe that will continue to be a big part of our growth going forward.

I wanted to add to that and tie it back to the incredible innovation engine you should keep in mind, too. Not only is the expansion working, but there are more products and features available to sell every quarter, which plays into our D&R strategy moving forward.

Very helpful from both of you. And then new customer generation was really robust in the quarter, a record, as you mentioned. Anything worth pointing out there as a driver or accounting for that strong new customer number?

Yes. I don't mean to critique your work, but your early note suggested that we now have 14,000 customers. In fact, we actually added 14,000 new paying customers in the quarter and are now at over 154,000 paying customers across the platform. I think that, again, is just us showing that regardless of the size of customer, we've been able to very effectively get them onto our platform, nurture them over time, get them to use additional products and services, and grow them into larger customers. When you look at growth like that, there's never one particular thing to point to and say, 'That was what was going on.' We've serviced a broad set of customers from very small to very, very large. I'm proud of the team's hard work that has delivered in continuing to grow our entire customer base. It's great to see us have a record addition of 14,000 new customers in the quarter.

Your next question comes from the line of Joel Fishbein with Truist.

Fantastic execution again. Matthew, a couple of other companies that are cloud-centric have reported that Internet traffic has been trending down over the past several months. I'd love to just get your take on what's happening and how Cloudflare is positioned and how your Internet traffic has been flowing.

Yes. We haven't seen that. I think it has been continuous growth. So to answer your question, just straightforward, we've seen year-over-year traffic growth across our network of 75.8%, and quarter-over-quarter growth of 15.9%. That's in line with the quarter-over-quarter growth that we've seen for the last period. It's worth remembering that we don't bill primarily based on usage. We bill in a much more predictable way. I think this is a good indication that we are taking share from the rest of the industry. Even in the post-COVID times, the traffic across our network continues to grow. We maintain above our target gross margins while doing so. I think the other thing which you didn't ask about, but I think is interesting to compare, is how much usage has grown across our network. Where bandwidth has grown 75.8% year-over-year, CPU usage has actually grown 89.1%. Over the quarter, it was 15.9% for bandwidth and 21.8% growth for CPU usage. What I think is interesting and important is that it shows that people are not just using Cloudflare for moving bits, but are using Cloudflare for intelligent processing, which is really driven by our Workers' edge computing product and some of our security products. It shows why we're able to continue to grow revenue at the 54% rate that we did in the quarter. Does that answer your question?

More than I wanted, but thank you. That was great. Appreciate it.

Your next question comes from the line of Brent Thill with Jefferies.

Matthew, the Area 1 acquisition, I think, is unique for you and kind of outside your core lane. Can you just talk to that? And also, when you think about the go-to-market and the synergies among the other suite, can you just talk through how you think that unveils over the next several quarters?

Yes. I think first of all, any acquisition is a bit unusual for us because we have such a strong bias towards internal development and building our products. However, Area 1 and e-mail security, in particular, makes a lot of sense for us to pursue. If you look across every protocol that is sent across the Internet, we protect HDB traffic, SIP traffic to your phone system, SSH traffic, any protocol. We just had not dived into protecting SMTP and the e-mail protocols. A bit of that is my fault and our CTO John's fault, because both of us worked in email security prior to coming to Cloudflare, and we have the scar tissue to show for it. All the time, our sales team would come and say, 'Customers really want us to have an email security product.' Our engineering team would say, 'We have a ton of data to help inform an email security product; we should build it.' John and I often vetoed that, which I think was a blind spot for both of us. If you look at the data, e-mail security is by far the #1 source of threats that come into an organization. Almost every headline hacking incident you've read about in the last two years started through email vulnerability. So I think it makes a lot of sense for us to have a solution. It's powerful because we are the DNS provider, and we can make it one-click deployment; our customers can click a single button and instantly get the benefits of the Area 1 solution while continuing to use their existing email provider, whether that's Outlook and Microsoft Office, G-suite, or an on-premise solution. Much like Cloudflare, Area 1 operates as a proxy for email traffic. I think it's a natural point for us to integrate. It integrates well with the rest of our zero trust suite. For instance, when you get an email from an unknown sender, we can automatically isolate that email using our browser isolation product, so any links clicked on in that email don't render on your laptop but are rendered at the edge of our network, stopping any malicious content. So I think this is going to be a very effective way to introduce our zero trust suite to the market. It gets people to adopt a seat-based approach to our product very easily; existing customers can deploy it with just one click. I believe it will serve as a gateway to sell more of our zero trust products, including our gateway, access, and browser isolation products as well. Does that answer your question?

That was very comprehensive.

Your next question comes from the line of James Fish with Piper Sandler.

Nice quarter there. I wanted to hear a little bit more about the wave 2 products like Teams and Magic Transit, especially as it seems these are driving the largest dollar growth still. Additionally, how has Cloudflare for Offices progressed this quarter? And is there any way to think of how many customers are at a penetration rate of using these wave 2 solutions?

Yes. I think the wave 2 solutions, and I would characterize it a little differently. I would say that we have products like Magic Transit and Magic Firewall that really complement some of our traditional products. They're focused on protecting content and infrastructure. Then we have products like Gateway and Access and Browser Isolation, which protect users. I think you could pump those into wave 2. That is true from a timing perspective, but they are somewhat different in terms of how we go to market with those products and who the exact buyer is within an organization for those products. We've seen really strong adoption for the Magic Transit product; it's replacing a lot of traditional network DDoS protection services. There's significant strength with carriers starting to use the product, which is exciting because we can stand in front of much more traffic than possible through any box-based solution. On the user-based products, we're seeing solid adoption from customers who come for those products and then also for us to sell them to existing customers. There is a natural link between our traditional firewall products and the access product, and those go together very well. I think Cloudflare for Offices continues to progress really well, although it's early to determine what that will look like. In the quarter, we announced some hardware we're deploying and started building that out within networks. Rather than measuring the success of that product based on revenue, we are more focused on the willingness of landlords and network providers to invite us into their facilities and allow us to directly interconnect. That is trending at or ahead of our expectations in every region where we deployed Cloudflare for Offices.

Your next question comes from the line of Phil Winslow with Credit Suisse.

Congrats on another great quarter. I wanted to focus on Workers and R2. You've talked about significant wins there, Matthew. One of the things you've also mentioned is that it takes time to reach escape velocity and a platform in terms of developer adoption, etc. How are you thinking about where we stand right now? Is there anything surprising you in terms of the rate and pace of adoption of Workers or the broader platform when you think about R2?

Sure. First, as I mentioned, R2 is going to progress from a closed beta to an open beta next week. We have Platform Week next week, which focuses on how Cloudflare can be a development platform, particularly our Workers' products. I believe we’ll have exciting surprises as part of what we're rolling out over the course of the week. If you study developer platforms, it usually takes between 8 and 12 years for them to reach escape velocity. Workers was launched in late 2017, so we're still on that curve. The surprising thing is that we're seeing very big companies with sophisticated development teams getting excited about Workers as a solution for many of their problems. The examples I mentioned earlier, one major social network with a very sophisticated developer team chose to build using Workers. Once a team like that sees the power of Workers, it excites them both within their organization and as they transition to new positions, taking the technology with them. The same is true with that Australian software company, where real-time collaboration across continents is much easier using Workers and durable objects than with traditional public cloud solutions, which often require substantial work. We have examples of how that's done, and it's very well-received by sophisticated software engineering teams. We expect these trends to continue, though it will take time for it to significantly contribute to revenue. I'm very pleasantly surprised by the developer interest in the Workers ecosystem, and we’ll discuss this further next week.

Your next question comes from the line of Keith Weiss with Morgan Stanley.

It's Matt Wilson on for Keith Weiss. Matt, you again mentioned the opportunity to use gross margins as a weapon against competitors who are more vulnerable to pricing and cost pressures. Can you detail what has allowed Cloudflare to resist these pressures, both on the pricing and cost front?

I think efficiency is at our core. Our network is designed to be as efficient as possible, which allows us to deliver our services. We sometimes get compared with traditional CDN vendors, but that's not our business model. If you're selling simply bit delivery, being faster results in diminishing returns. However, security and intelligence built into the network provide compelling use cases. From the beginning, we said that Cloudflare would never lose on price. This has enforced efficiency from the start. In today's environment, as companies search for ways to save on IT budgets, many vendors are trying to hold or raise prices. In contrast, we can push forward and take share, especially in high-margin segments from existing hardware vendors struggling to deliver products and other cloud vendors that aren't as efficient. This efficiency remains key to our story.

Thank you for those details. And maybe on this one for Thomas. When can we expect this gross margin strategy to show up in the numbers?

I'm not sure what you mean by showing up in the numbers. We have managed to digest significant revenue growth and traffic growth, as Matthew mentioned, while maintaining stable to slightly increased gross margins. I believe that's a testament to network elasticity. I reiterate that the ability for all products to run on every server in every city creates freedom to manage cost, demand, and supply more flexibly. You see that already with tremendous growth in all metrics.

Your next question comes from the line of James Breen with William Blair.

Just sort of on that point a little bit. Are you basically managing to kind of a breakeven non-GAAP operating income line, plus or minus a couple of million just to maximize revenue? And from an expansion standpoint, does building out more network and more points of presence allow you to go deeper into multinational companies that may not have access to you at this point?

Sure, Jim. We've been consistent about managing toward breakeven on our operating margin. I previously mentioned that if we showed massively positive earnings per share, it would indicate we did something wrong. If we continue to grow at the rates we are guiding, the best use for that money is reinvesting back into the business to grow it quickly. In that respect, we are managing towards breakeven on our operating margin. Regarding the POPs, I think we’re already in well over 100 countries. Our presence has rarely been a barrier for multinationals adopting us. The companies we highlight in examples are almost all massive multinationals who rely on our network. Our expanding POPs drive costs down, which is counterintuitive but due to our network efficiency and design. New POP locations help us interconnect with ISPs and eyeball networks globally, reducing variable costs for bandwidth and co-location, making further expansion feasible. Essentially, as we expand our network, efficiency increases and costs decrease.

Your next question comes from the line of Adam Borg with Stifel.

Maybe just for Matthew on the federal vertical. I hope you could provide an update on FedRAMP and the opportunities that you see. Obviously, you've seen some traction there with the joint win with Accenture, but just curious how you think about the federal opportunity in 2022 more broadly.

Yes. Federal is a big opportunity for us. We think we'll continue to unlock that. We've received thumbs up from our sponsoring agency and are just waiting in line with the overall federal agency to get that approved, which is going well. We've done everything we can do; it’s a bit like the DMV. You're waiting for your number to be called. We're confident it will be called sooner than later. This timing isn’t stopping us from working with Accenture and other partners, and we’ve seen significant interest. The trust we've built with federal-level executives is substantial; our team has received numerous calls from trusted individuals securing U.S. infrastructure. We launched, in partnership with CrowdStrike and Ping Identity, the Critical Infrastructure Protection Act. I was honored by the White House recommending that hospitals, utilities, and energy companies adopt that quickly. We have enormous goodwill with the government and see a significant opportunity to continue delivering on that goodwill. Any day now, I hope the FedRAMP DMV will call our number, and we can make announcements.

Your next question comes from the line of Alex Henderson with Needham.

First off, I wanted to compliment you guys on the great job you’ve done protecting the Ukrainian infrastructure and reporters, and continuing to deliver access to Western news flow into Russia—really important stuff. The question I wanted to ask was around internet traffic. Maybe you could share a couple of data points on the change in your coding total. The traffic up 75% is well ahead of marketplace growth of around 30%. So can you update us on the percentage of Internet traffic you're carrying? Additionally, API traffic has more than doubled over the last 18 months in terms of growth, from over 150% to something in excess of 300%, suggesting high growth rates in domain-user traffic, which is a key part of what you do, protecting and optimizing. Can you discuss your share and what the implication of that API growth rate is? I realize you're not being paid per bit, but that may imply rapid acceleration in domains being trafficked to.

Yes, Alex, first of all, thank you for the compliments. It's been a quarter where our team has worked tirelessly to keep Ukrainian infrastructure online and assist individuals seeking clarity on global events. I am proud of what they've accomplished, and I appreciate you acknowledging that. Regarding Cloudflare's percentage of Internet traffic, we know our numerator but lack a solid denominator. Instead, we use proxies; we currently serve around 20% of the top million websites. This doesn’t fully account for our additional products. From just a web usage perspective, that figure is around 20%. For APIs, we've consistently observed that more traffic through Cloudflare comprises API traffic. In this quarter, we unveiled our enhanced API protection suite, which has received strong adoption. It's worth noting that this encompasses many protocols, and our network excels at understanding this reality while safeguarding API interactions. Workers play an integral role; there is no simpler way to establish an API than using Workers. Look for numerous customer examples and further discussions on this next week during Platform Week.

If I could just add a question regarding India and China, can you provide an update on why that traffic isn't reaccelerating at a faster rate? And when will it start to eclipse company averages?

I don't think we've specifically broken out traffic from India and China nor do I know exact growth rates. In terms of revenue, both regions present interesting prospects, but they differ significantly. We've achieved success penetrating the Indian market and have expanded our services there, adeptly navigating a complicated ISP model. For China, we've always operated through partners. We've been in partnership with Baidu for a long time and recently brought JD Cloud on board. This collaboration is progressing well, but Western companies face complications when operating in China. Since 2015, our operations have demonstrated our ability to prosper. Generating revenue inside China isn't our exclusive goal; the value lies in our network extending into the region. This allows multinational companies to deliver services to every country on earth through a single network, which is a unique capability for us.

Operator, can we take one more question, please?

Certainly. Your last question comes from the line of Amit Daryanani with Evercore.

Perfect. I have two as well: first off, I was hoping you could discuss the growing concern of a recession in Europe and America. Are you seeing any shift in your customers' buying patterns, deal-closing rates, or anything from the recession risk? Second, on M&A, how is that embedded into your revenue and operating profit guide for the June quarter? What is the impact of these deals?

Sure. The history books will likely mark this as the most complicated quarter tech companies have faced since Q1 of 2020. There is a real risk of a recession ahead. We're witnessing inflationary trends concern businesses. What I find promising is that few companies are better positioned than we are. We're offering a service that is a must-have, not a nice-to-have, while actively saving customers money over their existing solutions. We've deployed a network that allows us to service customers as needed. In this quarter, we saw a heightened concern, but in many cases, that translated to customers approaching us. In challenging economic times, we are well positioned to deliver critical services, just as we did at the start of COVID where many customers consolidated their spending across multiple vendors and shifted to us. They appreciate our bundled integrated approach and the savings we offer over traditional solutions. I believe this positions us favorably during what will likely be a challenging period.

On your guidance question, we've adopted a thoughtful approach considering the exposure to Russia, Ukraine, and Belarus. As mentioned, that represented less than 1% headwind revenue in Q1, and we reflected this in our guidance for the current quarter and the entire year. The acquisition of Area 1 is included in guidance for both the second quarter and the entire year. This is true for both revenue, with less than 1% annual contribution, and the dilutive impact on profitability.

That's all the time we have for questions. I'd like to turn the call back to CEO, Matthew Prince, for closing remarks.

This has been a challenging quarter as we've observed world events unfold. I'm incredibly proud of our team for ensuring Ukrainian infrastructure remained online, allowing individuals to see the truth and relying on Cloudflare to face any challenges ahead. I sincerely appreciate all the effort from Cloudflare employees, and I value our customers. I look forward to seeing many of you at our Investor Day and Customer Day next week in New York, and stay tuned for a lot of announcements. It's going to be a busy week for us since it's also Platform Week, one of our Innovation Weeks, and we expect to announce several exciting features. Thank you very much.

This concludes today's conference call. Thank you for joining. You may now disconnect.