Cloudflare Inc

NYSE:NET

Earnings Call Analysis

Cloudflare's Strong Q2 2024 Performance Amid Challenging Environment

Cloudflare reported a robust second quarter of 2024, achieving $401 million in revenue, a 30% year-over-year increase, and surpassing $1.6 billion in annualized revenue. The company added 168 new large customers, growing its base to 3,046, and maintained a steady 67% revenue contribution from these clients. Despite economic uncertainties, Cloudflare generated $38.3 million in free cash flow. The firm projects third-quarter revenue between $423 million to $424 million and full-year revenue between $1.657 billion to $1.659 billion, indicating a 28% growth year-over-year. Free cash flow for the year is expected to be around $160-164 million.

Solid Financial Performance Amid Uncertain Times

Cloudflare reported a robust second quarter for 2024, achieving a revenue of $401 million, which marks a 30% increase year-over-year. This strong performance underscores the company's resilience and operational efficiency even in a challenging macroeconomic environment. Notably, the company reached $1.6 billion in annualized revenue and added 168 new large customers, bringing the total to 3,046, both reflecting a 30% year-over-year growth.

Strong Customer Growth and Retention

Cloudflare's customer metrics were impressive, with about 210,200 paying customers, a 21% increase year-over-year. Significant growth was seen among large customers, which now generate 67% of the total revenue, up from 64% last year. Though the dollar-based net retention rate declined by 3 percentage points sequentially to 112%, it still indicates a strong rate of customer retention and expansion.

Operational Efficiency and Profitability

The company demonstrated strong operational efficacy with a gross margin of 79%, exceeding the long-term target range of 75% to 77%. Operating expenses as a percentage of revenue decreased by 6% year-over-year, reflecting enhanced productivity and cost management. Sales and marketing expenses also saw a reduction, down to 37% of revenue compared to 41% in the previous year. Operating income increased significantly to $57 million, a sharp rise from $20.3 million the previous year, leading to a 14.2% operating margin.

Healthy Cash Flow and Financial Position

Cloudflare's financial health remains strong, with a free cash flow generation of $38.3 million, accounting for 10% of revenue. This is a notable improvement from the $20 million, or 6% of revenue, recorded during the same period last year. The company ended the quarter with $1.8 billion in cash, cash equivalents, and available-for-sale securities, ensuring substantial liquidity and flexibility for future investments.

Future Outlook and Guidance

Looking ahead, Cloudflare provided guidance for the third quarter and the full fiscal year of 2024. For Q3, revenue is expected to range between $423 million to $424 million, marking a 26% year-over-year increase. For the full year, revenue is projected to be in the range of $1.657 billion to $1.659 billion, a 28% year-over-year increase. The company remains prudent in its outlook, projecting full-year operating income between $196 million to $198 million and an effective tax rate of 11%.

Market Expansion and Strategic Wins

Cloudflare's growth was supported by several significant customer wins in different regions. Notable expansions included a $17.5 million contract with a leading Australian technology company, large strategic wins in the U.S. including a $5.7 million contract with a major university, and a $3 million contract with a Fortune 500 gaming company. These deals highlight the broad adoption of Cloudflare's comprehensive product portfolio, particularly in security and performance solutions.

Strong Innovation and Developer Adoption

The company's commitment to innovation was evident, with increasing adoption of its developer platform, Cloudflare Workers. The platform saw a 20% rise in active developers to over 2.4 million in just four months. Cloudflare Workers' AI functions also showed strong growth, with a 67% quarter-over-quarter increase in developer accounts taking advantage of these features, reflecting the platform's growing importance in AI-driven tasks.

Strategic Focus on Operational Excellence

Cloudflare emphasized its strategic focus on operational excellence, with improvements in sales productivity and a focus on high-caliber talent acquisitions. New hires in upper management reflect the company's dedication to scaling its operations and enhancing productivity. These efforts are expected to further drive growth and efficiency in the next quarters.

Earnings Call Transcript 2024-Q2

[Operator]

Thank you for standing by. My name is Kathleen, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cloudflare Second Quarter 2024 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Mr. Phil Winslow. Please go ahead.

[Philip Winslow, executive]

Thank you for joining us today to discuss Cloudflare's financial results for the second quarter of 2024. 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 will be making forward-looking statements during today's discussion including, but not limited to, our customers, vendors and partners, operations and future financial performance, our anticipated product launches and the timing and market potential of those products. Our anticipated future financial and operating performance and our expectations regarding future macroeconomic conditions. These statements and other comments are not guarantees of future performance and are subject to risks and uncertainties, much of which is beyond our control.

Our actual results may differ significantly from those projected or suggested in any of our 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 SEC 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. You may find a reconciliation of GAAP to non-GAAP financial measures that are included 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.

We would also like to inform you that we will be participating in the Stifel Tech Executive Summit on August 26 and the Goldman Sachs Communacopia and Technology Conference on September 10.

Now, I'd like to turn the call over to Matthew.

[Matthew Prince, executive]

Thank you, Phil. We had a terrific quarter, even with the continued macroeconomic uncertainty. We crossed $1.6 billion in annualized revenue, achieving $401 million in the second quarter, up 30% year-over-year. During the quarter, we added 168 new large customers, those that pay us more than $100,000 per year and now have 3,046 large customers, also up 30% year-over-year. Revenue contribution from these large customers during the quarter remained consistent at 67%, up from 64% in the second quarter last year. Our dollar-based net retention was 112%, down 3 percentage points quarter-over-quarter. Our gross margin was 79%, again, above our long-term target range of 75% to 77%. We delivered an operating profit of $57 million, representing an operating margin of 14.2%, underscoring our commitment to operational efficiency and productivity. We generated strong free cash flow of $38.3 million during the quarter, ahead of our expectations. This wasn't an easy quarter, but we continue to execute and deliver strong results.

While I think we benefit from being a must-have, not a nice to have, we still have to fight for every deal as the IT buying environment continues to be challenging, but our investment in go-to-market improvements are showing dividends. Turns out when you have the right players on the field, you can still play and win even in the rain.

In the second quarter, we again delivered another double-digit year-over-year improvement in sales productivity. In addition, close rates and sales cycles both also improved quarter-to-quarter and year-over-year. I'm proud of our team's execution.

I also couldn't be more pleased about the early returns from Mark Anderson and the other go-to-market leaders with proven track records who have joined the team. In Q2, Mark hired a new VP of Sales in the Americas a new VP of Revenue Operations and a Global Head of Customer Success. These are world-class go-to-market executives who recognize that we have the product, engineering and go-to-market leadership for them to bet their careers. As Mark continues to focus on operationalizing productivity at scale and building a world-class go-to-market engine a key focus in the second quarter involved making changes to the composition of our organization and bringing on more stage appropriate talent. This really shows in the numbers.

The sales manager and AE hiring in Q2 was up 150% quarter-over-quarter and 163% year-over-year. Again, the key to the quarter was excellent execution. We expect these additions to our go-to-market team to further add to our already building momentum with large enterprise customers, partners and the public sector that we again delivered during the second quarter. That's a great segue to discuss some of our wins in the quarter.

A leading Australian technology company expanded their relationship with Cloudflare, signing a 2-year $17.5 million contract, $7.2 million of which is expansion. They started with Cloudflare back in 2016 as a free customer and today use nearly all our products, spanning use cases as diverse as remote application access, Workers [ cedulas ] development and bot management. Over the next 2 years, this customer expects to transmit over 180 petabytes and 3.9 trillion requests per month and they see Cloudflare as essential to handling that level of connectivity while maintaining security. This is a great example of a land and expand customer who started with our free tier, sees the value and expands over time.

Sticking down under another leading Australian technology company, expanded their relationship with Cloudflare signing a 3-year $2.6 million contract for 18,000 seats of gateway, access, browser isolation, CASB, DLP and also our workers' development platform. This customer evaluated Cloudflare against three leading vendors in the market and selected us due to our superior technical solutions, network performance and future road map. The customer called us after the deal closed and said, "you were the best solution today, but also for the future, and the most strategic." We're very excited for this. One of the largest universities in the United States signed a 5-year $5.7 million contract. This customer is going all in on Cloudflare's SASE platform with 20,000 seats of Zero Trust, CASB, DLP, e-mail security, Magic WAN and Magic Firewall.

This university approached us looking to modernize and scale their global network as their incumbent on-premise solutions created bandwidth challenges and poor performance. With Cloudflare, they are able to replace multiple legacy vendors with a unified platform and cloud-first architecture. A large global research and development organization expanded their relationship with Cloudflare signing a 2-year $846,000 contract for Cloudflare's SASE portfolio with 3,500 seats of access, gateway, CASB, DLP, browser isolation and Magic WAN, along with our advanced application security bundle. This was a very competitive process to displace legacy VPN providers and Cloudflare was selected over three SASE competitors due to our superior network performance, ease of use and configuration as well as our unified platform.

A Fortune 500 financial services company expanded their relationship with Cloudflare signing a 1-year $895,000 contract for Magic Transit and Magic Firewall, gaps in their incumbent products with two on-premise vendors, let this customer vulnerable to attacks creating significant urgency for our placement solution. A number of channel partners mention Cloudflare is a leader in DDoS to this customer, and we are quick to come in and get this customer fully deployed, operational and protected in just 10 days.

A Fortune 500 gaming company signed a 2-year $3 million contract for advanced application security and performance along with R2 storage. This customer was looking to improve availability for its technical infrastructure to support its large global distribution of games. They are migrating all services from two incumbent vendors to Cloudflare due to the completeness of our solution, our superior network performance and scale and unified platform giving them a single control plane.

A leading AI company signed a 1-year $500,000 contract with Cloudflare to be their platform for AI for inference, storage, image optimization and application security. This company was an existing R2 customer, allowing them to unlock the best prices and performance across multiple cloud providers. However, doing both training and inference with a centralized hyperscale cloud created poor performance for their end users. With Cloudflare, this customer now has access to GPUs deployed across our network, close to their end users, not only will influence task be more performant, but this customer is also realizing a 40% cost improvement with Workers' AI.

A leading technology company expanded their relationship with Cloudflare signing a 2-year $4.8 million contract. This customer is focused on growing their enterprise and FedRAMP product lines and uses Cloudflare for government, along with Cloudflare Workers to dynamically route traffic in order to optimize reliability. This customer has significantly increased their usage as they unlock new use cases and lean further into standardizing on Cloudflare wherever possible across all their business units. After signing this deal, their team reached out to express interest in our AI products, so there should be more to come from this customer.

I think there are two trends that stand out across all those customer stories. First, customers are adopting Cloudflare broader platform and signing pool of fund deals that can have some revenue recognition and DNR impacts, but we believe it is actually an extremely healthy sign as when customers buy into our broad platform that we know of no competitors that can match our feature set.

Second, you'll notice that more and more of these large deals include Cloudflare Workers, our developer platform. Last quarter, I announced that we crossed 2 million active developers on the platform. I checked in just the other day, and we're already up to more than 2.4 million active developers and over 20% increase in just the last 4 months. This accelerated adoption following the announcements during our developer week in early April, reinforces how developers are increasingly seeing Cloudflare as offering a complete solution for them to build and ship full stack applications.

Workers' AI is growing even faster, with developer accounts taking advantage of our AI functions, increasing 67% quarter-over-quarter. Today, we have inference tuned GPUs live in 167 cities worldwide, making us, we believe, the most global cloud inference solution, and inference requests powered by Cloudflare AI increased more than 700% quarter-over-quarter. Developers are turning to Cloudflare for their AI tasks that need to be fast, global and compliant with an increasing patchwork of AI regulations.

There's external validation as well. Stack Overflow recently surveyed a broad base of developers on what platforms they're using today. Cloudflare came in fourth, just off the podium, ahead of 22 other developer platforms and behind only the three traditional hyperscale public clouds. What's even more exciting, however, is what the survey tells us about the future. When developers were asked what platform they were the most excited to work on in the coming year, Cloudflare came in second, ahead of AWS, Google and Microsoft Azure. Cloudflare didn't even make the survey in 2022. So we're coming out fast. If we continue to increase developer interest at the same rate, it won't be long before we metal. And rest assured, our team won't be satisfied with anything short of gold. With that, I'll hand it off to Thomas, who looks after our gold to walk through our financial results. Thomas, take it away.

[Thomas Seifert, executive]

Thank you, Matthew, and thank you to everyone for joining us. We are pleased with our execution during the second quarter as we make continuous progress on our go-to-market transformation. We again delivered another double-digit year-over-year increase in sales productivity during the second quarter. And we also saw an uptick in close rates and an improvement in sales cycles. The quarter was highlighted by sustained momentum with large new customers, ongoing significant progress in the public sector and continued high prioritization of security by our customers. Continuing our strong commitment to being fiscally responsible and acting as good stewards of investors' capital, operating profit again more than doubled year-over-year, and we generated free cash flow of $38.3 million during the second quarter.

Turning to revenue. Total revenue for the second quarter increased 30% year-over-year to $401 million. From a geographic perspective, the U.S. represented 51% of revenue and increased 28% year-over-year. EMEA represented 28% of revenue and increased 32% year-over-year. APAC represented 13% of revenue and increased 29% year-over-year. We were pleased to see a notable upticks in both sequential and year-over-year growth in APAC as a number of go-to-market initiatives in the region begin to deliver early returns.

Turning to our customer metrics. In the second quarter, we are at about 210,200 paying customers, an increase of 21% year-over-year. We ended the quarter with about 3,050 large customers representing an increase of 30% year-over-year and an addition of 168 large customers in the quarter.

Our dollar-based net retention rate was 112% during the second quarter. representing a decrease of 3 percentage points sequentially. The decline in DNR was driven by slower net expansion in our larger customer cohorts, increased platform deals in the form of pool of funds contracts, which reduced friction to adoption across our product portfolio but can impact the shape of revenue recognition as well as deferred revenue and current RPO, especially for existing customers that transition into this structure and anniversarying the price increase to our Pro and business pay-as-you-go plans last year.

For the next several quarters, we expect new customers to contribute a higher percentage of our overall year-over-year revenue growth. similar to the second quarter.

Moving to gross margin. Second quarter gross margin was 79%, representing a decrease of 50 basis points sequentially and an increase of 130 basis points year-over-year. Network CapEx represented 6% of revenue in the second quarter. Based on the timing of certain investments, we expect network CapEx to increase in the second half to reach 10% to 12% of revenue for full-year 2024. Turning to operating expenses. Second quarter operating expenses as a percentage of revenue decreased by 6% year-over-year to 65% as we remain committed to driving higher productivity and great efficiency across our operations. Our total number of employees increased 15% year-over-year, bringing our total head count to 3,902 at the end of the quarter.

Sales and marketing expenses were $149.5 million for the quarter. Sales and marketing as a percentage of revenue decreased 37% from 41% in the same quarter last year. This decline was primarily due to the transition in our go-to-market organization to focus on more stature appropriate talent. We are encouraged by the acceleration in account executive hiring exiting the second quarter which Matthew mentioned earlier, and we expect this trend to continue in the second half of 2024.

Research and development expenses were $65.4 million in this quarter. R&D as a percentage of revenue decreased to 16% from 17% in the same quarter last year. General and administrative expenses were $44.7 million for the quarter. G&A as a percentage of revenue decreased to 11% from 13% in the same quarter last year. Operating income was $57 million compared to $20.3 million in the same period last year. Second quarter operating margin was 14.2%, an increase of 760 basis points year-over-year. These results highlight our continued focus on becoming more efficient and more productive, given that operational excellence is a long-term competitive advantage.

Turning to net income and the balance sheet. Our net income in the quarter was $69.5 million or diluted net income per share of $0.20. We ended the second quarter with $1.8 billion in cash, cash equivalents and available-for-sale securities. Free cash flow was $38.3 million in the second quarter or 10% of revenue compared to $20 million or 6% of revenue in the same period last year. Remaining performance obligations, or RPO, came in at $1.421 billion, representing an increase of 6% sequentially or 37% year-over-year. Current RPO was 69% of total RPO.

Moving to guidance for the third quarter and full-year 2024. We are pleased with our execution during the second quarter, and we remain prudent in our outlook for 2024. For the third quarter, we expect revenue in the range of $423 million to $424 million, representing an increase of 26% year-over-year. We expect operating income in the range of $50 million to $51 million, and we expect an effective tax rate of 11%. We expect diluted net income per share of $0.18, assuming approximately 359 million shares outstanding.

For the full-year 2024, we expect revenue in the range of $1.657 billion to $1.659 billion, representing an increase of 28% year-over-year. We expect operating income for the full year in the range of $196 million to $198 million. We expect an effective tax rate of 11% for 2024. We expect diluted net income per share over that period to be $0.70 to $0.71, assuming approximately 358 million shares outstanding.

We are currently analyzing our ability to implement certain tax planning strategies in order to manage current and future cash tax liabilities. We will provide an update once this tax planning review is completed if the outcome were to impact our expectations for Cloudflare's non-GAAP effective tax rate in the second half of 2024. We expect free cash flow to be consistent with our implied prior guidance of approximately $160 million to $164 million for the full-year 2024.

In closing, our team remains committed to driving operational excellence, ensuring long-term growth and delivering significant shareholder value. I'd like to thank our employees for their dedication to our mission as well as our customers for trusting us to help them modernize, transform and secure their businesses. And with that, I'd like to open it up for questions. Operator, please poll for questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Matt Hedberg of RBC Capital Markets.

[Matthew Hedberg, analyst]

Congrats on the quarter. Obviously, it's a challenging environment. And to see the consistency is really, really great. Matthew, maybe to start with you, it was really seen in other quarter of double-digit sales productivity improvements. I guess what are some of the most important changes, Mark Anderson and I guess the broader team is implementing to drive that result? And -- and given that you said macros remain challenging, is increased productivity also helped the cause of really accelerated sales cycles and improved close rates?

[Matthew Prince, executive]

Yes. Thanks, Matt. I think we've tried to be very transparent about what we were seeing. I think the real nature for us in sales productivity was in Q3 of 2023. And then this quarter, we're back to the same sales productivity that we saw back in the -- in mid-2022. So we're -- it is rebounding well. I think Mark Anderson gets a lot of credit for that over the last bit. But the real change has started even before Mark joined us. And I think we're starting to -- we're already seeing the benefits of the changes of just really putting in place much better operational metrics, putting in place much better training, really up-leveling our team, having the discipline to do performance management and then have that flow through. And I think that's a lot of what you're seeing today. What Mark is doing is accelerating that even more. And that starts with hiring really excellent lieutenants and really excellent leaders. It's a dramatic upgrade across our entire sales organization. And then what's been just amazing to watch is great people want to follow great people. And so Mark has a huge number of amazing people who want to follow him -- those people who have followed him now are bringing in and up-leveling our team. And what we're seeing is not only are they more productive, but then they're helping our existing team who really amazing people, get more productive as well.

So I think disciplined execution, that started before Mark Anderson. I think it's accelerating with Mark Anderson. And we have never had a product problem. We've never had demand problem that's here and what every sales leader who comes in, says is, I just can't wait to roll up my sleeves, put in place the real discipline and get out to selling what is an incredible product.

[Matthew Hedberg, analyst]

That's great. Sounds like a real flywheel effect. And maybe just a quick one for Thomas. In your prepared remarks, you noted that DNR ticked down 3 points sequentially. And obviously, this is a trailing 12-month metric, and you called out a number of factors that negatively impacted that metric. I guess the fact that you raised full-year revenue guidance more than the Q2 beat, does that imply DNR has bottomed? Or could it see some further pressure given that you noted a larger percentage of revenue growth will come from new customers in the future?

[Thomas Seifert, executive]

Yes. So there -- as we said on the -- in my prepared remarks, the decrease was driven by so a net expansion but it was also impacted by what Matthew described, large pool of funds deal. So as we ended this fiscal year, we've entered into several of these pool of funds deals. They are all very large in nature, the biggest ones anywhere between $40 million to $60 million of total contract value. As a matter of fact, 4 of our top 10 customers are now pool of funds customers. And these pool of funds deals are generally built monthly as compared to upfront annual billings and they tend to have a longer durations. So most of these contracts are north of 3 years. And as a result, the financial impact of these pool of fund deals is very different. It's very different on revenue, and it's different on the current RPO and it's very different on deferred revenue. And if it's an existing customer that transitions, it also impacts DNR. So as it relates to revenue, the revenue is now recognized as the customer consumes the service, and as a result, the record revenue recognition might be nonlinear and might ramp over time with respect to deferred revenue because those deals have monthly billing terms, we do not report upfront deferred revenue, and this can result then in lower deferred revenue growth. And then current RPO is also impacted because the contract duration is longer. So you recognize upfront less in current RPO. So while there the deals are very beneficial and healthy to the business. They generate some noise in this transition in our DNR and in the other metrics.

So very healthy trends. We'll make the business a little bit more lumpy as of last year. I still think those KPIs are the right KPIs. But I think you have to look at them more from a rolling average perspective, but very healthy development, very large deals, but with some noise and lumpiness in the transition.

[Operator]

Your next question comes from the line of Shaul Eyal from TD Cowen.

[Shaul Eyal, analyst]

Congrats on the results and what appears to be a swift action by Mark and the entire team. Matthew, given the recent CrowdStrike IT outage, which was on-premise predominantly. My question is whether Cloudflare was called by some customers to assist given your cloud connectivity capabilities and focus and whether you could be seeing some longer-term benefit given this focus? And I have a follow-up.

[Matthew Prince, executive]

Yes, Shaul. I think we get called to help customers all the time, but we don't have a product that directly competes or replaces CrowdStrike. I think the first thing I'd say is that our whole team, we offer to help CrowdStrike directly in any way that we could, helping them get patches out or releases out helping review any communications that they had. And they have been a great partner. We are a customer of theirs and we continue to have faith in their product and George and the rest of its leadership team. I think more generally, though, the word of the day is going to be resilient, which is that customers are going to want to make sure that they are not sole sourced on any one vendor. And that includes with vendors like the ones that are providing network security like we do at Cloudflare.

And so when we're talking to large financial institutions, what they're saying to us is we want to use you and someone else. That, I think, is going to put pressure on some of the older, more legacy providers. I think for us, it actually is potentially a tailwind for us because in places where before we had to convince someone to rip and replace. Now instead, we just have to say, you need to have a second provider in place. And since we have been the disruptor in the market moving from the low end up and increasingly going into larger enterprises.

I think it actually opens up more and more opportunity for us over time. So what I'm hearing from customers is that resilience is key that people are increasingly not wanting to be entirely reliant on any one vendor. And I think that especially in larger -- in the larger accounts that we're going after, that is actually going to open up an opportunity for us to get in because it means we can sit side by side with someone else.

What's great, though, is our performance is better, our security is better, and we know time, and time, and time again, if you put us next to anyone else in the CASB space, anybody else in SASE space, anyone else that these vendors are looking at, we may start out as the #2 vendor, but very quickly, they realized that we should be #1.

[Shaul Eyal, analyst]

Understood. And I was listening carefully to your prepared remarks as it relates to the product seems as if you're hitting on all cylinders. Magic Transit, virtual firewall, SASE, Workers, you name it. But the question is whether there was any specific one or two product, services that stood out specifically this quarter?

[Matthew Prince, executive]

I think the first thing I'd say is that and this really echoes what Thomas was just talking about. When we say that people are signing up for a pool of funds deals, what they are really signing up for is to use the entire Cloudflare platform. And so more and more, we're seeing that people are saying, I'm not picking you for one feature or another. I'm picking it because the entire platform gives me a solution to all my network performance, security and reliability needs. And so I think that's what's driving a lot of our larger deals with our larger customers. And I think that's an incredibly encouraging results. If you force me to pick one area that's really standing out, it's got to be the developer platform. I was blown away that just quarter-over-quarter, we've seen 20% increase in active developer accounts. That is especially showing up in the Workers' AI platform. We've been able to partner with folks like Meta to be able to get the latest versions of Llama out on our platform, and developers are just flocking to it. And so I think that if you look around in our developer channels, our discord channel, if you look around on Twitter, you'll see that more and more developers are betting the future of whatever their application is on the Workers' platform, and they found that they can use us and us alone to build future applications, which, again, every day, I get a new report from our team just saying, you won't believe what somebody built on Cloudflare Workers. So if you force me to pick one thing, I'm going to say Workers was the real state out of the quarter, but generally, it's been the platform.

[Operator]

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

[James Fish, analyst]

Look, I know it's not a metric you guys completely focusing in on, but it was the largest net customer additions. I think you guys have had as a public company in aggregate. So Matthew, you've had a phenomenal track record of really calling out IT spending trends, and you did say some tightness still.

And so my question really is how are customers balancing this tightness with sort of that potential total cost of ownership savings by moving on to a Cloudflare versus kind of new projects and how are you kind of thinking this could change in terms of IT spending, if at all, in the second half as budgets begin to be set later this year for next year, actually.

[Matthew Prince, executive]

Yes. Maybe I'll start, and then Thomas might have something else to add. So I do think that it continues to be a challenging IT buying environment, and this was by no means an easy quarter. I'm proud of our team and execution was really, really the name of the game here. And I think that, that increased execution will pay dividends even as the IT environment inevitably does rebound over time. But that -- our crystal ball still shows that it's challenging flooding for the overall IT environment over the quarters ahead. I do think that we benefit by being something that companies must have, while IT budgets might be getting cut in marketing tech, in productivity tech, and other spaces. I think security is one of the areas, and we've had so many high-profile security incidents over the first half of this year. The security is an area where people are continuing to invest. But what I think is really powerful about Cloudflare is we don't just solve one security need. We solve the totality of customer security needs. And so oftentimes, when a customer is signing one of these pool of funds deals, they're replacing two, three, four different vendors and consolidating behind Cloudflare.

And so I think that what we see over time is that the network security space is the area that we want to own, soup to nuts, and that we can completely have that as a solution for customers. And in times where IT budgets are tough, that is a place where people want to consolidate, they want to consolidate on a single vendor and we are a beneficiary of that.

[Thomas Seifert, executive]

Yes. I just wanted to add to your introduction. It was a very strong net customer add quarter, mainly driven by three effects. So we had a onetime benefit because we migrated billing platforms, and there was a catch-up, but beyond that onetime benefit, it was a very strong customer quarter driven by our two customer increase, up 32%. And at quarter-over-quarter in the second quarter as well as the increase in developers on their Workers platform that Matthew talked about. So those three factors were driving the car. So a very strong quarter.

[James Fish, analyst]

Makes sense. And you guys obviously pool of funds is another theme of this quarter. And Thomas, you had just said a few moments ago, I believe, that it was 4 of the top 10 customers are now on this type of contract. So -- is there a way to understand how much of RPO is now on the sort of pool of funds path even just those four at that kind of $50-ish million average rate would imply about 15% of RPO today? And additionally, what could that look like kind of a few years down the road?

[Thomas Seifert, executive]

Well, I will not give you that final information. But what you just said, I think this is a good indication. We've always been asked how we drive customer revenue up and how you can get to a 3-digit million dollar ACVs and TCVs, cooler funds will be that path, and then Matthew outlined the reasons for that.

In addition to the pool of funds deals, we -- in the second quarter, we also entered into a handful of very large subscription arrangements, all well north of $5 million. And those are more predictable from a revenue recognition and forecasting perspective, but there's very similar impacts on RPO and deferred revenue. So in addition to the pool of funds structure impacting us generating this lumpiness in the quarter, and we were also successful signing a very large subscription arrangements in the second quarter too.

[Operator]

Your next question comes from the line of Andrew Nowinski of Wells Fargo.

[Andrew Nowinski, analyst]

Congrats on another amazing quarter. So I wanted to ask a bit of a techy question to start here. As it relates to your Edge AI and your OHTTP offering, I know you're one of the cofounders of OHTTP, but I was wondering if you could comment on how your customers might be using it as a way to preserve data privacy and maybe give us an idea on the revenue opportunity there?

[Matthew Prince, executive]

Sure. And this might -- I'm not sure how to do this and not make it a little bit geeky, but OHTTP, the original spin of the cloud -- the original sin of the Internet is that your -- forget cookies, forgetting anything else, your IP address alone reveals a ton about who you are, where you are and a bunch of other things.

Your IP address in your home, for instance, doesn't change all that often. And so even without cookies, even without anything else, people can build profiles of you. As privacy has become more and more important as we -- and then recognized as being more and more important online. I think one of the things that our team with a number of other industry partners and leaders has really focused on is how can we eliminate that original sin? How can we disassociate your IP address from your identity.

And so OHTTP is a technology that does it. The best way to think about it is, it's essentially two hops in the system. So if your device connects to the first proxy that is out there. That proxy knows what device connected to it. But then it can use encryption to wrap that, that identity piece up looks like putting it in an envelope and handing it off to a second proxy. And that second proxy is the only thing that knows where that traffic is going. So one party can know who is behind something and the other party can know where they're going, but neither party knows both, where any one individual is going. So you can imagine in the case of like a handset manufacturer, they may operate that first proxy because they operate the handsets themselves, but then hand that off to a third party like Cloudflare in order to never have the information about where their customers go online.

I think that what's interesting about this is that the very nature of the protocol requires an independent third party. So at no point, can the handset manufacturers say, we're going to complete the soup to nuts. They have to have an independent third party. And the third party of choice in this, I think in large part because privacy has been so core to who Cloudflare is and what we do is one of our five core values in terms of when we think about products, and because of just our breadth and technical expertise, as more and more companies are thinking about this and recognizing that both for philosophical reasons, but then also for regulatory reasons, that they need to be as private as possible. Cloudflare is that preferred place to be that second hop in an OHTTP solution.

So I have been -- I think we built this for some very specific and I would have thought relatively limited use cases. I am surprised how many different use cases this is now getting introduced into. And I think that as AI continues to develop it's an area where a lot of people are rethinking the privacy of the Internet and thinking about how can we -- they incorporate more modern standards. And to that extent, I think you will see that if there is continued growth in this space, it actually may be a lot of the AI companies that are leading, leading in that direction.

[Andrew Nowinski, analyst]

Great. That was really helpful. Maybe a question for Thomas as well. Just really impressive operating leverage in the model and a strong guide for the year. And I know you're not giving fiscal '25 guidance yet, but given the substantial raise to your operating margin for this year, I was wondering if you could at least tell us how you're thinking about operating leverage next year and whether you'd expect operating margin expansion above the new guidance you gave for this year.

[Thomas Seifert, executive]

Yes. Nice try, but I'm not going to give guidance for next year. But I think over the years, we have been good stewards of investors' capital, and this will continue. Me, Matthew and Michelle described how we -- the philosophy, how we run the business really well and as long as we see a market that is this large in terms of TAM that we can disrupt and deliver strong growth rates and investment into Cloudflare, the best return for the money that we earn. And keeping this balance in terms of how we think about the business of growth rate and operating leverage, I think, served us well. And we'll continue, we will not deviate from this philosophy in next year, but that I will shy away from giving you guidance.

[Operator]

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

[Adam Borg, analyst]

Maybe just building off the last question a little bit and even tying it back to some of the wins you talked earlier on AI. How do you think about the inference opportunity overall when you think about hyperscale clouds, obviously, the edge network that you built as well as your edge device themselves, how do you think about how that relationship looks like today and how that evolves over time?

[Matthew Prince, executive]

Yes, Adam, my take is that inference is primarily going to happen in two places. The first is on devices themselves. And that you can already see what a number of handset manufacturers and others are doing to bring more powerful GPUs and TPUs directly to devices. And my rough hand way, I have no idea if it will be right, but just as a mental model is that maybe 50% of inference tasks gets handled on your device. But there will always be either devices which are older and maybe don't have the latest chips on them or models that are bigger and require more compute power than your handheld device is able to deliver. And in those cases, you're going to hand that inference pass off to something else.

One model of that is to send that back to Ashburn, Virginia or some centralized sort of traditional public cloud. I think that, that, especially because of the concerns around privacy, because of the regulatory concerns where AI is getting just rapidly regulated that you're going to want to keep that as close as possible. That also has the benefit of making it as performant as possible. And it also means that you can have the AI that's responding have regional differences more easily so that if you're responding in the U.K., the -- an AI can spell color with a U, whereas if it's in the U.S., it can spell it with no U. I think all of those things then drive a lot of the other 50% of inference tasks to be running at a network like Cloudflare. And so we are trying to build that network out ahead, make sure that we can answer any inference tasks that can't get determined on your own device as close as possible to that device and then make it very easy to get that inference task from us are from the device to us in a standard-based API-driven way, so that it's seamless to that end user.

There will still be some tasks that maybe will be even too big to run at us, although that is becoming a smaller and smaller list of tasks. And maybe there's some small percent that makes its way back to a traditional hyperscale public cloud. But I really think that inference is going to be between the end devices themselves and a network that is like Cloudflare that spans the globe and is incredibly close and in every jurisdiction where end users might be.

[Operator]

Your next question comes from the line of Fatima Boolani of Citi.

[Fatima Boolani, analyst]

Matthew and Thomas, this is for you both. I had a bare picture question around the pricing strategy across the portfolio. So at a tactical level, you had some meaningful price increases that you're first ones ever. Thomas wondering if you could just opine on how far deep those have pervaded the installed base. And if you can kind of talk to where we are in terms of the innings in terms of how that inferred in the base?

And then Matthew, the bigger picture question for you is, if I piece together a lot of what you shared in the prepared remarks as it relates pool of fund deals, more pay as you go, more consumption, payment modalities especially as the Workers' portfolio scales, how should we generally think about the business impact and sort of revenue elasticity, if you will.

[Matthew Prince, executive]

I'll start and then Thomas can add and I think we might both have something to say on both pieces. So we're about a year after a price increase across our pay-as-you-go business. That is -- it's an important part of our business, but it is a relatively small part of our business. I think we, for a long time, we're very reluctant to raise prices on that part of the business, but we had added so much value that we just thought that it was the right, right thing to do. And we were really incredibly pleasantly surprised how many of the customers, the pay-as-you-go customers, not only even didn't -- our churn rates were tiny due to that price increase. But really, I actually wrote to us and said, about time because there's so much more value that you've added. And that was good. Pricing creases didn't apply across the rest of the platform. So enterprise customers results the customers we talk about on these calls, there wasn't any, any dramatic price increase there. I think we are always trying to find ways to have the highest ROI for our large customers. And typically, we can be a substantial savings over whatever the existing vendors are in the market. And because we have the efficiency in our business, we can do that while still maintaining 78%, 79% gross margins. Our long-term target gross margins are 75% to 77%, and we've been coming in ahead of that. And again, very healthy software-like gross margins even for a business with the operational complexity and intensity that we have. And I think that, that's what allows us to be -- to deliver the returns that we can. Generally, I think philosophically, what we want to do is be the network for all of our customers. And we want to solve all of the problems that a customer has around their network. And so we think of it as being their connectivity cloud and that connectivity cloud works great with whatever devices and things they have on-premise works great with whatever they're running in a traditional hyperscale public cloud, but we're that connectivity layer that sits between those things. And that's a very, very, very substantial opportunity and one that I think we have only just started to really, really penetrate.

[Fatima Boolani, analyst]

I appreciate that.

[Thomas Seifert, executive]

There's not much to add to what Matthew just said. Some of the impacts of this transition, you have seen, we talked about how pool of funds deal impact the lumpiness or make our numbers a little bit more lumpy. We will also have an increasingly higher share of variable revenue in our numbers, while this number is still small today, and it will grow meaningful over time.

But this is less driven by price increases, as Matthew said, but it's more driven by the structural changes that this transition implies. And with all the overall benefits of more stickiness, longer-duration deals, platform fills with better expansion capability and significantly higher total contract values.

[Operator]

Your next question comes from the line of Hamza Fodderwala of Morgan Stanley.

[Hamza Fodderwala, analyst]

Matthew, I just had one question on public sector for you. We saw a lot of strong momentum in the public sector space in the federal space over the last year. I'm curious as we head into the federal fiscal year close in September, what that momentum has been like, especially ahead of what's going to be an election in November. What are you hearing from the agency customers that you work with?

[Matthew Prince, executive]

Yes. So federal has been a real point of strength for us ever since we started investing in it, and ever since, we achieved FedRAMP certification, which really unlocked a lot of U.S. federal business. But we've seen also strong government business around the world.

I would say, first of all, the election is incredibly important. We couldn't have built Cloudflare without a stable functioning democracy and you can't have stable functioning democracies unless you have elections that people can trust. And so since 2016, actually directly in response to the -- a lot of mistrust and tempering in the 2016 election, we launched what we call the Athenian Project, where we provide our services at no cost to anyone who is helping administer an election around the world. And -- or excuse me, rather around the United States, although we've increasingly started doing it in select countries around the world as well.

And I'm incredibly proud of the work that we do on this to help support what are largely unsung heroes, and I don't care if it's a red state or a blue state or a purple state. Like if you're helping administer an election in some county around the United States, you're real patriot and a real hero and you need all the help and protection that we can give. And I'm proud of the fact that our team on a pro bono basis provides the full suite of our services to the people who are administering elections because I think it's fundamental for the success of our country and our country is fundamental to the success of the company. So I'm not sure that the election itself drives significant upticks in spending, and I feel kind of a little gross if it did, because I think it's our duty to provide our services in these cases. What I will say is that I think most of the people who are listening in on this call would say that it's not always the most rational thing to go work for government certainly doesn't pay the best. With government officials that I've talked to, the public servants that I've talked to, again, across the political spectrum, what they all are is very mission-driven. And they believe in the mission of -- in the United States of this country and the importance of that. And I think that they very much respect when they see companies like Cloudflare step up and say, it's not just all about how we collect the most revenue, but it's how we do the right thing to protect the underlying function of democracy. And so when you hear about us winning big deals that are big numbers and large revenue-producing deals. I think a lot of that comes from the fact that we are thought of extremely well by those incredibly patriotic, very mission-driven people who are public servants. And when they're thinking about when they have a hard problem that they are going to pick a vendor for who they turn to the work that we do on things like the Athenian Project and protecting elections. It's part of why we've had the momentum and the success that we've had with the federal business. And I think that, that will continue and only accelerate over the quarters and years to come.

[Operator]

Your next question comes from the line of Trevor Walsh of JMP.

[Trevor Walsh, analyst]

Maybe just one question for me and maybe a couple of parts. Matthew, you had a good win story that you had in your prepared remarks. I think it was with the Australian tech company SASE deal, where they had also purchase Workers. Curious how much you're leaning into those SASE deals where an Act 3 product such as Workers is kind of coming into the fold? And how kind of important of a differentiator you see that within that particular market? And then as a follow-up, you had your Descaler campaign last year to kind of handle your campaign against one particular competitor in that space. Just curious if you're seeing that overall competitive landscape shift at all kind of in the last 12 months and if we might see a similar campaign against another competitor there? Just maybe just get your overall thoughts about who you're seeing in the deals and if there's other players kind of coming up from different parts of the market that are not the standard ones that you've come up in the past.

[Matthew Prince, executive]

Yes. I think that the thing that we can do that's very difficult for any, any point solution vendor to compete with is provide a comprehensive solution. And so again, if the theme is pool of funds, platform deals, broad deals, Workers is a part of that. It is not as big of a part as our traditional application security. If you -- it doesn't make any sense if you're going to do a SASE deal to not have the same vendor also providing your DDoS mitigation, and we're really the only vendor in the space that can do both the traffic coming into your network and the traffic going out from your network. But it's just a network like the network should be smart and it should be that you should provide one kind of holistic solution.

I don't know yet of any real vendors where people have said, Oh, I'm -- are any real customers where people have said, I'm going to choose your SASE solution because of Workers. There are places where people are using Workers and then they either use our SASE solution and those things go together. But I think you'll start to see more of that going forward. The really powerful thing comes back to sort of the origin story of Workers itself. We didn't build Workers to sell it to the developer platform. We built it because we saw all of these opportunities, and we needed a developer platform for our internal team, customer zero to be able to build different solutions. What's powerful about that is that, that then means that, that same platform can be used to adapt, configure, or customize any of the solutions that are built on Workers more so than you can with any other vendor that's out there because you're using that same developer platform.

I don't think that -- I don't think we're there yet in terms of customers. I think we're still in the kind of just get it up and running stage. And not just us, I think across the entire space, SASE is a new enough category. But over time, I think when people go from saying, first of all, I want a secure network. Secondly, I want to make sure it's reliable. Third, I want to make sure that it is fast, it's performance. I think the next thing that people come to is I want to make sure it's programmable. I think we are still kind of in the secure and reliable stage. I think customers are coming to us away from some of the first-generation, Zero Trust and SASE vendors because we are secure, reliable and fast. But over time, secure, reliable, fast and programmable is a pretty killer combination that I don't think there's any other vendor out there that's going to be able to match.

[Operator]

That concludes our Q&A session. I will now turn the conference back over to Mr. Matthew Prince for closing remarks.

[Matthew Prince, executive]

Just wanted to say thank you to the entire Cloudflare team. This quarter, really, the theme was execution and you guys executed incredibly well. Thank you to the team. Thank you to all of our customers. It continues to be a complicated world out there. The Cloudflare is helping better secure networks everywhere around the world. Thank you all. See you back here next quarter.

[Operator]

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.