Good afternoon. My name is Emma, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cloudflare Second Quarter 2022 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. Thank you. Jayson Noland, VP of Investor Relations, you may begin your conference.

Thank you for joining us to discuss Cloudflare's financial results for the second 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 uncertainties, some of which are beyond our control, including, but not limited to, challenging general economic conditions, including inflation, rising interest rates and other impacts of the ongoing COVID-19 pandemic and Russia-Ukraine conflict. 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. We would also like to inform you that we will be participating in the Stifel Tech Executive Summit on August 30th, the Deutsche Bank Technology Conference on September 1st and the Piper Sandler Growth Frontiers Conference on September 13th. Now, I'd like to turn the call over to Matthew.

Thank you, Jayson. Even with the increased economic uncertainty, we had a very strong quarter. In Q2, we achieved revenue of $234 million, up 54% year-over-year. We added a record 212 new large customers, those paying us more than $100,000 per year, and now have 1,749 customers over this threshold. These large customers now represent 60% of our revenue, up from 50% six quarters ago. This trend illustrates how large, established enterprises increasingly form the foundation of Cloudflare's business. In fact, today, 29% of the Fortune 1,000 are already paying Cloudflare customers, a nearly threefold increase over when we went public less than three years ago. Our dollar-based net retention remained strong at 126%, down 1% over last quarter. While there may be some noise in this number from quarter to quarter, we won't be satisfied until it's above 130% and best of breed among the companies we consider peers. Our gross margin remained strong at 78.9%, up 90 basis points year-over-year and still over our long-term target of 75% to 77%. Our operating margin was right at breakeven, which continues to be our plan so long as we can deliver strong growth. What I'm watching closely is our free cash flow margin. It showed significant improvement quarter-over-quarter, and we continue to forecast it will be positive in the second half of the year. On our last earnings call, I received a lot of raised eyebrows from many of you when I said Q1 of 2022 would prove to be the hardest quarter for our industry since Q1 of 2020. It didn't make me particularly popular around the CEO club, where the first rule of recession is not to talk about recession. However, transparency has always been one of Cloudflare's core values, so I'm going to call it like I see it. In that spirit, let me share some more details of what we saw and are seeing. In Q1, our pipeline generation slowed, sales cycles extended, and customers took longer to pay their bills. We watched those metrics closely throughout Q2 and saw them all at least stabilize. They're not where we would celebrate yet, but the metrics are trending in the right direction. Given our visibility early into the economic downturn, we rapidly adjusted our go-to-market message. We shifted our messaging to focus on ROI, helping customers save money and consolidating spending from multiple point solution vendors behind Cloudflare's broad platform. Messages about saving money and using fewer vendors didn't particularly resonate a year ago, but they do today. Having a broad platform to solve so many customers' problems while at the same time saving them money is a superpower in times like these. As I look at our wins in the first half of the year, I believe it's fair to say that it's harder today than it was a year ago to sign up a new customer, but it's gotten easier to talk to our broad set of existing customers about doing more with us. And customers are eager to hear about how we can save them money, reduce their IT complexity, all while increasing their security, performance and reliability. I'm not an economist, so I'm not the person to say whether we're in a recession or not, how bad it may be, or how quickly we may rebound. But I am the CEO of Cloudflare. And while our business remains strong, I believe this is a time for prudence and caution. The metaphor I've been using with our team is to talk about the different conditions you may face driving a car on the road. A year ago, we could see for miles and the road was clear, so it made sense to open up the throttle. Today, we find ourselves in what my grandmother used to call tule fog. The road ahead is less certain, so it makes sense to keep our hands on the wheel, our eyes on the road, and let up a bit on the accelerator. Whether we're in one or not, recessions are tough. They hurt everyone. No company is recession-proof. But some are more recession-resilient than others. Some things I know are universally true. No matter how bad this recession may get, companies aren't going to abandon the Internet. They're not going to give up on the cloud and go back to on-premise boxes and packaged software. Hackers aren't going to stop hacking, so cybersecurity will remain a must-have, not a nice-to-have. And we're already seeing evidence of all of this, with our gross renewal rate in every region for the first half of the year hitting all-time highs since we went public. We are not recession-proof, but I wouldn't trade places with any other CEO right now. Personally, if I think back, my career has been defined by recessions, I think a lot of people's are. Recessions have always been hard, but they're also formative moments to focus and ultimately improve. In 2000, as the first dot-com bubble burst, the law firm I was supposed to go work for decided they didn't need any more securities lawyers, but they could probably find a spot for me in their bankruptcy practice. At just that time, I reflected on whether watching companies implode was what I wanted to do with the rest of my life and pivoted to become an entrepreneur. 14 years ago, in 2008, at the onset of the last global recession, Google pulled their full-time offers for all their summer interns, which included my co-founder at Cloudflare, Michelle Zatlyn. If that hadn't happened, Cloudflare would have never been born. At the same time, I learned what a margin call was and, simply embarrassingly, literally had to borrow money from my mom to pay my rent. That's when I got an extremely personal lesson on the importance of free cash flow, and it's why I'm ensuring right now in this uncertain time that Cloudflare is prioritizing being free cash flow positive. Tough times force you to reevaluate everything you've done and become better. It's why the best companies come out of tough times even stronger than they went in. So, maybe it's a bit masochistic, but I'm looking forward to having Cloudflare get even better during some of the tough times for the global economy that seem likely ahead. Hands on the wheel, eyes on the road, letting up a bit on the accelerator. With that background and to avoid being too much of a downer, let's talk about some great customer wins in the quarter. A Fortune 500 retailer in Europe signed a $1 million three-year deal for multiple Cloudflare products. They wanted to reduce their operational complexity by replacing a number of point solutions with Cloudflare's broad platform. We became their web application firewall, content delivery network, bot management system, and several other application protection services with our easy-to-manage platform. Having proven success protecting their infrastructure, we're now talking to them about expanding to be their Zero Trust provider, too. A Fortune 500 energy company signed a $784,000 three-year deal. They had been using Zscaler. They found Cloudflare solutions easier to use, more performant and integrated across their full security control plane. As I said last quarter, we like our win rates when we go head-to-head with Zscaler and Palo Alto Networks because our product is better and can scale to meet the needs of complex organizations like this one. And while we're still relatively new to the Zero Trust space, we're going head-to-head against them more and more often. Yet another Fortune 500 industrial company signed a $1.3 million five-year upsell agreement. This customer first adopted Cloudflare in Q1 of 2022 and is already seeing ways they can use more of our platform. What’s also notable is this is an example of us increasingly working with channel partners. We believe channel sales are especially important in the Zero Trust space. In Q2, we successfully signed up half of Zscaler's top channel partners as new Cloudflare partners. The State of Arizona expanded their use of our platform, signing a $770,000 one-year expansion deal. Arizona has been a long-time Cloudflare customer and continues to expand the use of our platform as we launch new products. I still remember their first purchase order with us from several years back, which specified the address and method of shipping of our products as if we were a hardware vendor. We shipped them T-shirts, not hardware, and they have continued to grow with us ever since. One of the world's largest advertising conglomerates signed a $1.7 million one-year deal. They originally came to us last quarter under an attack that originated out of Russia. Seeing the power of our platform, this quarter, they expanded their engagement. This was yet another competitive Zero Trust deal against other leading Zero Trust vendors. Like we're hearing over and over again, this customer chose Cloudflare because of the strength of our broad platform and our ease of use. In the words of their head of cloud: 'With Cloudflare everything works, there are no issues.' One of the largest online recruiting firms signed a $5.5 million three-year deal. They were an extremely technical buyer who put our entire platform to the test. In the end, they demonstrated for themselves that we were, by far, the best in breed. This is also an example of how increasingly we're seeing executives bring Cloudflare to their new workplaces. In this case, the buyer knew us from his previous position and was our champion when he moved jobs and was promoted. In his words: 'You don't get fired for buying Cloudflare.' Workers continues to gain traction among developers. Last earnings call, I talked about the importance of building Workers into other platforms as the best shortcut to developer adoption. In Q2, we signed deals with one of the largest e-commerce platforms, one of the fastest-growing web development platforms, and a next-generation database platform to embed Workers as a service as a preferred development environment. These deals represent hundreds of thousands of dollars in guaranteed revenue with upside as usage grows. But more importantly, we believe they are the fastest path to catalyzing a robust ecosystem around Cloudflare Workers and exposing its power to the broad community of developers. Another interesting thing to note from the quarter is we're increasingly seeing other security companies adopting Cloudflare as the best-of-breed solution. It's incredibly affirming when your peers choose your product. A public security compliance vendor, a leading endpoint security provider, and one of the largest data security vendors all signed multiyear contracts each worth more than $700,000. Even our direct competitors often use Cloudflare for DDoS mitigation and other services where we are the clear leader. This recognition by our peers of our best-of-breed products continues to validate why I'm confident Cloudflare will continue to grow even stronger through the tough economic times that may be ahead. One last thing in the spirit of transparency before I turn it over to Thomas. We had a bug in our billing system related to how we expire unused credits for pay-as-you-go customers. Before we went public, for good accounting reasons, we put in place a policy where we expired unused credits after three years. That system triggered for the first time earlier this year. Unfortunately, a bug in it caused our systems to report a spike in total paying customers last quarter. The revenue involved is not material, less than $160,000, and it caused us to over-report the number of paying customers last quarter. The correct numbers are 148,184 in Q1 and 151,803 in Q2. Our pay-as-you-go business is only 11% of our revenue today, but we believe it's important to continue to invest in it in order to serve the entire market and protect our play. I'm embarrassed by the mistake, and we've fixed the bug and put in place checks designed to catch any similar errors in the future. I don't like it when we make mistakes. But I do think it's important we be transparent and own them when we do, which is why I insisted on addressing this today. It also leaves more fun topics for Thomas. With that, I'll hand it off to Thomas to walk through the financials.

Thank you, Matthew, and thank you to everyone for joining us. We delivered another strong quarter driven by strength in our large customers with a record number of large customer additions as we continue to build our expansion engine. Our success in the first half of this year reflects the investments in our innovation and large enterprise go-to-market initiatives as well as the benefits of operating a durable, subscription-based revenue model. Turning to revenue. Total revenue for the second quarter increased 54% year-over-year to $234.5 million. The growth in revenue was driven by strong adoption of our product portfolio and continued traction with our enterprise customer base. Area 1, the email security company we acquired in April, contributed less than 1% of revenue. From a geographic perspective, we saw continued strength in both the U.S. and internationally. The U.S. represented 53% of revenue and increased 55% year-over-year. EMEA represented 26% of revenue and increased 54% year-over-year. APAC represented 14% of revenue and increased 43% year-over-year. We are pleased to see growth continue to accelerate in APAC. Turning to our customer metrics. In the second quarter, we had 151,800 paying customers, representing an increase of 20% year-over-year. We saw a higher level of churn due in part to pay-as-you-go customers shifting down to our free customer tier. As our business continues to move up market, the total revenue contribution from our pay-as-you-go business, which largely reflects SMB, continues to decline, representing 11% of revenue in the second quarter, down from 14% in 2021 as disclosed at our Investor Day in May. Turning to large customers. We ended the quarter with 1,749 large customers, representing an increase of 61% year-over-year, and a record addition of 212 large customers in the quarter. We were pleased to see large customer revenue contribution increase again sequentially. We continue to move up market, shipping products and features that are enterprise-grade, and that is reflected in our large customer cohorts, consistently increasing size and revenue contribution. Significant expansion from our large customers contributed to a dollar-based net retention of 126%, representing a decrease of 100 basis points sequentially and an increase of 200 basis points year-over-year. While we expect DNR to continue to trend upward over time, we expect some variability quarter-to-quarter. Moving to gross margin. Second quarter gross margin was 78.9%, representing an increase of 20 basis points sequentially. Network CapEx represented 13% of revenue in the second quarter. We continue to expect 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. Second quarter operating expenses as a percentage of revenue increased 3% sequentially and decreased 2% year-over-year to 79%. We had another strong hiring quarter, where we saw our total number of employees increase 49% year-over-year, bringing our total number of employees to approximately 3,060 at the end of the quarter. As we look forward into the second half of 2022, we plan to slow the velocity of hiring given global macroeconomic uncertainty. We also see an opportunity to raise the bar on new hire additions given dislocations in the market. Sales and marketing expenses were $103.9 million for the quarter. Sales and marketing as a percentage of revenue increased 2% sequentially and decreased to 44% from 45% in the same quarter last year. Research and development expenses were $46.2 million in the quarter. R&D as a percentage of revenue increased 1% sequentially and stayed flat from 20% in the same quarter last year. General and administrative expenses were $35.8 million for the quarter. G&A as a percentage of revenue stayed flat sequentially and decreased to 15% from 16% in the same quarter last year. Operating loss was $891,000 compared to an operating loss of $4 million in the same period last year. Second quarter operating margin was negative 0.4%, improving 220 basis points year-over-year. If not for our acquisition and continued investment in Area 1, we would have been operating profit positive. Turning to net income and the balance sheet. Our net income in the quarter was $312,000 or net income per share of $0.00. Tax expense for the quarter was $793,000. We ended the second quarter with $1.6 billion in cash, cash equivalents and available-for-sale securities. Free cash flow was negative $4.4 million in the second quarter or 2% of revenue compared to a negative $9.8 million or 6% of revenue in the same period last year. Operating cash flow was $38.3 million in the second quarter or 16% of revenue compared to $7.5 million or 5% of revenue in the same period last year. We will be diligent in balancing operational discipline moving forward. We have a heightened focus on free cash flow while maintaining profitability at or near breakeven with continued investment to address the enormous opportunity in front of us. As mentioned in prior quarters, we continue to expect to return to positive free cash flow in the second half of 2022. Remaining performance obligations, or RPO, came in at $760 million, representing an increase of 10% sequentially and 57% year-over-year. Current RPO was 76% of total RPO. Before we move to guidance for the third quarter and full year, I would like to provide additional color on our expectations in light of the uncertainty in the macroeconomic environment. Similar to the early days of COVID, we performed rigorous analysis to understand both the risks and opportunities in the current environment. However, while COVID particularly affected a narrow set of industries, the current challenges impact a broader set of verticals, which is why we believe it's important for us to be more prudent in this quarter's guidance. Headwinds from foreign exchange have also accelerated. And with our product portfolio priced in U.S. dollars, our products are becoming more expensive internationally. And while we haven't seen a material change in our customers' behavior to date, we are seeing elongated sales cycles at the high end of our business. We are cognizant of the increasingly cautious environment and factor this into our outlook. For the third quarter, we expect revenue in the range of $250 million to $251 million, representing an increase of 45% to 46% year-over-year. We expect operating income in the range of $0.0 million to $1 million. We expect net income per share of breakeven to $0.01, assuming approximately 342 million common shares outstanding. We expect a tax expense of $1.9 million. For the full year 2022, we expect revenue in the range of $968 million to $972 million, representing an increase of 47% to 48% year-over-year. We expect operating income for the full year in the range of $7 million to $11 million. We expect net income per share over that period in the range of $0.03 to $0.04, assuming approximately 343 million common shares outstanding. We are fortunate to be uniquely positioned as a provider of mission-critical services to our customers. And while there are challenges in the economy, we remain excited about the opportunity in front of us. We'd like to thank the Cloudflare employees for their continued dedication and resiliency in delivering exceptional service to our customers, partners and communities. And with that, I'd like to open it up for questions. Operator, please poll for questions.

Your first question comes from the line of Matt Hedberg with RBC Capital Markets.

Thank you for the question, and congratulations on the results in a challenging environment. Thomas, Matthew provided valuable insights, and we appreciate his honesty. You mentioned longer sales cycles, yet you still raised your full-year guidance by $13 million, exceeding the $7 million beat in Q2. Can you elaborate on how you considered levels of conservatism in your projections? Are you expecting conditions to remain steady or potentially worsen from here?

Yes. We looked at a lot of different factors impacting guidance this year, and you picked up some already. So, we continue to see elongated sales cycles at the high end of our business that is especially in the $0.5 million to $1 million bucket, and we expect that to continue. We saw also that our European business was the second best-performing region this quarter, and we've seen deterioration of performance, especially in Europe over the first and second quarter. So, we expect that the trend for sure not to improve. We also see across the board, I think, the companies are like us becoming more cautious in how they approach the business and things that are discussed twice in order to make sure that that has only been done once. So, we have not factored in our guidance that things would improve from here on moving forward, and perform rigorous analysis across verticals, across various regions and customer cohorts. And that's why you see a more prudent and more cautious guide for the third quarter and the end of the year.

Got it. That makes sense. And then maybe just one for Matthew. The wins that you called out in Workers are exciting. I guess, I'm wondering, is there an opportunity maybe more challenged economic times for customers to start to use Workers and even more creative, maybe cost-effective higher ROI ways than they would have otherwise done so, if like you said, the road was kind of clear ahead and no clouds or fog in front of us?

Yes. I think one of the really powerful things about Workers is its efficiency. A workload, an equivalent workload running on Workers versus running on any of the traditional public clouds, AWS, Google Cloud or Microsoft Azure, is typically significantly less expensive to run. And the technical work in order to make that happen is part of the magic of what Workers delivers. And so, we are definitely seeing especially in either new startups or people who are really realizing that they've got to make money stretch further. The days of just wildly spending on your cloud bill, I think, are behind us. And there are many ways, both with Workers and just some of our standard products, that if you put us in front of your typical public cloud, we can often save you quite a bit of money. Again, I think that was a message that didn't resonate very much a year ago, where it seemed like money was free and people were throwing it at any problem that was out there. But in these particular environments where people are trying to figure out how to stretch a dollar even further, Workers and Cloudflare's platform as a whole are very effective at helping people save money.

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

Actually, intra-quarter was an interesting release from you guys that you talked about the Cloudflare one partner program, and Matthew, in your prepared remarks, you mentioned taking some of your competitors’ top channel partners. Can you go over some of the details that you expect in terms of how this program is going to work for you guys? Is it solely focused on security? And how this is going to impact your indirect mix and profitability over the next couple of years?

Yes. I think that from the early days of Cloudflare, we explored various partner programs. And the challenge was that for a lot of our early products took five minutes to sign up, and they just worked out of the box, and so there wasn't a lot of value to add as a value-added reseller. And so, while we had what I would call fairly standard success for the SaaS industry in working with partners, I don't think our products really facilitated getting the most out of the partner ecosystem. A handful of things have happened. One is that our products have gotten more complicated, and the ability to customize them in various ways has become much richer. For example, with Workers, what we're seeing from a partner like IBM is that they can actually develop their own intellectual property for a particular industry vertical, deploy that on Workers, and then sell that same intellectual property over and over again. That's great for them. It really drives their services revenue, and it's great for us because it means that we are getting more leverage in what we're able to deliver through partners. The second thing is that I think we saw with Zscaler that their success with a handful of partners in selling Zero Trust products was really successful. Those products take more work to actually implement and deploy within an organization. It's not a five-minute setup. In that case, that's an area where we are able to work with partners. We're very much following the playbook. When we talk to the partners that are selling Zero Trust services, they all want to have more solutions in their basket to be able to bring to customers. Because in many cases, the previous Zero Trust solutions suffered from a lack of ability to scale, real performance bottlenecks, and not having the total global coverage that global companies need, and Cloudflare addresses all of those things extremely well. I think that that's an opportunity for us. In terms of profitability, the good news is that these more complex products tend to actually be the highest margin products that we have. As we were designing the program, we thought it could be both margin accretive to Cloudflare while also being very attractive to the potential partners that are bringing that to market. I think this is an area that we're watching very carefully. I think it's a part that we are going to continue to invest in. It is also one of the hidden benefits of us acquiring Area 1 as they had a lot more experience with the channel and with partners. Working with the team there to really design that program has been great, and the reception from partners has been terrific. I think that this is a win-win for us and for our partners.

Very helpful, Matthew. Last one for me is a big government quarter coming up here. And obviously, you guys have just some integrated relationship. I guess, what are you seeing on the government agency side and that FedRAMP program? Thanks guys.

Yes, I appreciate it. We are waiting for our FedRAMP certification, currently at number 84 while number 83 is being processed. We expect positive updates next quarter. We're also seeing increased adoption of Cloudflare services in the government sector, not just at the federal level but also with entities like the State of Arizona. This is a strong area for us, and as we obtain more certifications, it will enable us to move even more quickly.

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

I was hoping you could talk a little bit about the context of the commentary around economic conditions. It's pretty obvious the entire planet, the economies globally are decelerating. And particularly, Europe is under a lot of duress. But your initial comments were sort of that you saw that start to really manifest in Q1 and that it actually improved somewhat or at least stabilized in Q2, yet you sound a lot more cautious on your thought process and so forth. I'm wondering if there's a little bit of a disconnect between those two, the tone of those two. It doesn't sound like your business has rolled at all and sequentially got worse or more tense. On the other side of the coin, you sound like you're being much more conservative in your outlook. So could you parse between those two a little bit?

Yes, Alex. I think that what we see is that the environment has gotten harder. I think we saw the first signals of that actually going back to December of 2021, and they really started to manifest in various ways, slowdown of pipeline, slowdown of customers paying their bills in Q1 of this year. We talked about that on the last quarter's earnings call. I think some people were questioning why would we do that? What we've been able to do, though, because we saw that, we acknowledged it. We didn't pretend everything was normal, was really adjust to take advantage of the situation. One of the real powers of Cloudflare's business is the diversity of our customer sets, both on a geography and also industry basis, the diversity of our products, and that allows us to have multiple levers to be able to continue to deliver even when the times get tough. If you go back to the COVID quarters, that was definitely a time where we had to adjust how we went to market, what we did, what types of customers we focused on. We transitioned from being a business-driven primarily from getting new logos to one that developed a real expertise in how to go to our existing customers and sell them more. I think there are a lot of analogies for the sorts of adjustments we've made that allowed us to have a quarter like this. But make no mistake, we're still in what my grandmother would call a tule fog. We've still got to go out and do the work every day of filling up the wheelbarrow with new leads, sifting through it to look for the most promising, and being able to deliver. What I like about our business is, again, it's diversity across customer types, customer sizes, products, ways that we can go to market. I think our team has done a good job of adapting to a much more difficult situation today than it was a year ago.

Alex, maybe one additional point. I pointed that out in my script, but I didn't mention it in the previous answer. What we do feel is also currency headwinds, especially in Europe. So, even if the economic activity for us in terms of deal volume would be the same, we see the headwinds from a currency perspective in Europe, but also in other parts of the world, Japan, for example, that we need to digest.

Yes. This brings me to the second question I wanted to ask. The European environment is particularly challenging with a 20% impact from currency translation in EMEA, alongside inflation and rising interest rates. The Bank of England just raised rates by 0.5% today. Given this situation, companies are grappling with significant price increases, especially for systems in local currencies plus the currency translation, while their budgets remain relatively flat. It appears there is a distinction between companies offering low-priced, high-value technologies and those selling more expensive technologies. Can you discuss whether you are competitively priced? The lower upfront cost provides a considerable advantage in that region due to this dynamic, and are you experiencing more pressure in the higher-value, larger transactions? This seems to be a critical factor in determining success in Europe.

Well, I think it's certainly a benefit that our products are mission-critical. But even then, at the high end and bigger ACV deals, decisions take longer. That's where you see the elongated sales cycles. The second factor in our favor is that gross margin is one of the strong points of the business model. When we deploy that web and we always talked a bit audit as a strategic weapon where it makes sense. That doesn't mean price cutting. We try to be strategic and accommodating where we think it makes sense to build business relationships and business. But we are using our margin to accommodate that without any doubt.

Congrats on a set of results. Matthew, the first question for you. So, lots of discussions throughout the quarter, maybe some chatter around your crypto exposure, potential implications. A good opportunity here to address Cloudflare's exposure, and maybe your current thinking on this vertical, given the changing dynamics we've seen in recent months.

Sure. We have customers in that area, including several large exchanges, but none of them would rank in the top 10 customer list. Overall, I'm not certain about the exact exposure; Thomas might have more to add. However, I can say that it's not significant enough to be considered a major risk internally. I've personally never aligned strongly with either side of the crypto debate—there seems to be a lot of polarization. I feel I'm somewhat neutral on crypto; we haven’t invested heavily in it, but we have made sure that if opportunities arise, we can take advantage of them. It hasn’t presented any major challenges for us.

Yes. Our exposure to crypto was mid-single digits in percent of revenue, under 5% for the second quarter. So, it’s an interesting part in terms of the size and the amount of customers, but not a significant exposure to revenue.

Understood. Thomas, could you provide insight on the lengthening of sales cycles? I realize this varies among customers, but can you give us a general idea of how much these cycles are extending? Are we looking at an increase of two weeks, three weeks, or even more? How should we consider this?

I would say for the main part of our business, we are still far below 90 days from a sales cycle perspective. So, when we talk about elongated sales cycles, it's in the upper end of our cohorts where you look at the bucket, $500,000 to $1 million of ACV where it's moving out. But there, it's moving out by weeks, not by days.

Your next question comes from the line of Fatima Boolani with Citi. Thomas Seifert, CFO, stated that for the majority of our business, we are still well below a 90-day sales cycle. When discussing elongated sales cycles, it refers mainly to the upper range of our cohorts, specifically the $500,000 to $1 million annual contract value segment, where the timelines are extending by weeks rather than days.

Matthew or Thomas, jump all for either one of you. Thinking about the shift to pay-as-you-go customers, some of your observations and commentary around elongating deal cycles that you just addressed. I'm curious if you can just sort of take a step back and bifurcate for us how new logo land purchasing and procurement behavior has changed versus expansion or installed base expansion customer behavior over the last three months. If you can help contextualize this or put this under the lens of your product pillars, whether there is more or less usage or slower adoption of certain pillars versus others and certainly against the hardware supply chain constraint backdrop that we're in right now.

Certainly. As I mentioned earlier, it has become more challenging to acquire new clients since the start of the year. However, it has become easier to engage with our existing customers about utilizing more of our platform to address their issues. Our extensive product portfolio enables us to have meaningful discussions with current customers on how we can streamline their IT infrastructure, reduce costs, and enhance their security. This remains appealing to them. We continue to bring in new clients, but overall, the process of acquiring new customers has become more difficult, while discussions about increasing the use of our platform, particularly with different products we offer, have gained traction. Regarding product mix changes, security remains a primary focus area. There was significant concern following the Russian invasion of Ukraine about potential cyberattacks against Western companies. While we didn't see that risk emerging in the first quarter, there was an uptick in such incidents in the second quarter. It is not yet a definitive trend, but we are observing an increase in attacks on companies, leading them to seek our assistance. In this context, our security products are performing strongly. We are experiencing notable growth across our security portfolio.

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

Matthew, at Analyst Day, you talked about acts in these large markets that Cloudflare is to go after, notwithstanding the macro environment. Is there anything that has changed in your philosophy about these big markets? And maybe you can just give us an update on these acts or large markets and where you're positioned maybe specifically around R2 and the big data that you have going on right now? Thank you.

Yes. We think of Cloudflare as stacking multiple adoption curves one behind another. Our first acts were how do we protect the infrastructure of customers around the world. It is incredible to see how we've been able to succeed where today, more than 20% of all websites use our infrastructure. We're continuing to sell those products, but I think that we are earlier in that curve with our Zero Trust products and we're able to go to all of those people who adopted our application security products and say, 'Hey, we can help you with Zero Trust as well.' I think that's the big act that we're focusing on right now. Act three for us, which will really start to hit in a material way around revenue in three to five years, is around Workers. We've been pleasantly surprised how that adoption has happened faster and sooner than we expected. R2, which is our object store and our Amazon S3 competitor, went into public beta last quarter, and we expect that it will go into General Availability right at the end of Q3. I think that's an opportunity for us to do more and we continue to invest in it. We believe that the real durable nature of Cloudflare is that we're able to continue to stack these acts one behind another.

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

Matthew, maybe a question on the security angle for you. You talked a lot about having larger platform conversations with your existing customers. Can you comment on when you talk to CIOs, CISOs at these customers what is their willingness to really want to transform and modernize their existing security architectures versus perhaps continuing to refresh their existing on-premise data?

Morgan Stanley is a valued Cloudflare customer, and we have an excellent relationship with their CIO team. They are an organization that embraces change. I believe most organizations today recognize the need to adapt and are willing to engage in that discussion. What has shifted is that even those who thought they could keep investing in on-premise hardware are finding the current circumstances challenging. For instance, if you want a new firewall today, the wait times can be as long as nine months, and at the same time, firewall vendors are increasing their prices. Many of the results observed among traditional firewall vendors are likely due to customers securing their position in line. However, it’s not a good strategy to tell customers they must pay more while also delaying product availability. Even those organizations that previously stated they did not support moving to the cloud are starting to change their perspective, and it's becoming increasingly uncommon to believe that on-premise hardware can adequately address these issues.

Matthew, maybe a question on the security angle for you. You talked a lot about having larger platform conversations with your existing customers. Can you comment on when you talk to CIOs, CISOs at these customers what is their willingness to really want to transform and modernize their existing security architectures versus perhaps continuing to refresh their existing on-premise data?

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

Maybe just for Thomas, I think you talked in the script about being more judicious and slowing hiring in the back half of the year. I was hoping you could talk a little bit more about which areas are still prioritized in terms of hiring and which ones you're kind of slowing a bit more. Thanks so much.

Yes. We grew quite a bit employee headcount wise in the second quarter. We said we take the velocity down quite a bit. We still prioritize go-to-market open positions and protecting people moving into the second half. So, the slowdown is in G&A and some of their R&D functions, but go-to-market is still going to continue to hire.

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

Great. Maybe just a follow-up question on the operating income for the year. Your loss in Q2 is actually better than your guidance. I think you just said you're slowing hiring in the second half of the year. So, I assume the reason you lowered your operating income for the full year fiscal '22 was due to the Area 1 acquisition. If so, could you just pull that out? Maybe tell us what your organic revenue and operating income would have been outside of that acquisition?

Yes. I don't want to give much more specific than the color we gave in our script. But it is true with a couple of moving parts. Without the continued investment in Area 1, we would have been operating margin positive, probably more in the single-digit, mid-digit million dollar range for the second quarter.

And I assume the operating guidance for the year would have gone up in absence of that acquisition then?

We gave guidance for the quarter that took into account a lot of variables, and I am not going to parcel out now what the specific impact of Area 1 would have been if we hadn't done that acquisition. So, guidance is the holistic picture on many things that move and you should take it as such.

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

Matthew, could you provide some insight into your comments about DBNR? You mentioned an ambitious target of 130%. What do you think will be the key factors in achieving that? Is it more about your current position relative to macroeconomic conditions and budget constraints, or are there internal changes or focuses you are considering to help increase that figure? Thank you.

Yes. I think that it really is for us about how we bundle products together. Today, 29% of the Fortune 1000 are already Cloudflare customers. If you fast forward with that, I think that a very significant percentage of the Fortune 1000 are going to be customers. What we really want to focus on is how do we get them to use more of our platform. I think that what's unique about Cloudflare is we've got the products in place where we can have those customers adopt more and more of our platform. Not a single customer uses every single feature of Cloudflare's platform today in terms of contracted customers. That's where we really see that growing. That's a very healthy way to expand spend with customers, to become more and more critical. What we want to be is the network that the Fortune 1000 relies on for connecting to the internet, making sure that they're secure, making sure that their employees have the best experience possible and ensuring that no matter what happens, they're always going to be online.

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

Could you just talk a little bit about the CapEx? It's up a bit this quarter, a little bit higher than the guidance for the year, the range for the year. How you think about that spending going forward? Maybe some of the puts and takes on cash flow relative to top line growth and where are areas where you can generate cash without too greatly impacting the top line? Thanks.

Maybe I could start on CapEx. I mean, we're going to stay within the range that we guided for the year. We said before, you will see variability quarter to quarter just in terms of how we purchase, where we see opportunity to pull in spend and make sure that we maneuver ourselves smartly around the supply chain disruptions you see. This is pretty much driving the variability quarter to quarter, but we will stay within the range we guided for the year. From a free cash flow perspective, we said we have a lot of levers at hand. One of the biggest levers is moving to annual billing for our large customers. We are, from a company history perspective coming from a pay-as-you-go business where people gave us a credit card even at the beginning of the second quarter; the majority of our revenue was monthly billing. So we've made significant strides in that direction with annual billing. We have a lot of opportunities still in front of us. I would say this is the biggest lever, but we run a pretty holistic cash conversion project across the Company that looks into literally anything that can positively impact free cash flow generation. It's a cross-functional project, and we're making good progress, as reflected in the second quarter numbers.

Your next question comes from the line of Gray Powell with BTIG.

All right. Great. Thanks for taking the question. Congratulations for the strong results. So, yes, Matt, you called out the Fortune 500 energy company where you replaced Zscaler. Could you just clarify, are those mainly on the ZTNA side with Cloudflare Access, or were there some gateway wins as well? Can you drill into a little bit more and talk about why you won? Is it more on price, technology, or a combination of those?

Yes. When we sell our Zero Trust solutions, we really believe that the pieces all fit together. Sometimes somebody will just adopt one portion of the solution, but we prefer to sell a holistic solution and see how all of the pieces fit together. In terms of where we win, what we hear from the space is that our products are significantly more performant. We have a much more holistic solution where we can protect mobile devices in a way that many other providers can't. We can operate across various geographies. When I was traveling in Africa this time last year using our products, they worked great, whereas most providers in the space don't have that broad of a network that can deliver. We have literally two orders of magnitude more capacity to handle the forward proxy traffic than any of the other providers in the space. I think that's why we've been able to displace some competitors while they tried to adopt Zscaler and found it less user-friendly, generating a lot of IT support tickets. That's really not our focus. Our focus is going after all of the on-premise firewalls and hardware and VPNs that exist in the universe. We can be successful while they are too, but I think we have a better product. Over time, I think that will help us win.

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

Matthew, on Area 1, I know it's early, but can you give us an update on what you're seeing there? And I guess, again, on the last question, can I squeeze one in at the end? Thanks.

The Area 1 tech is amazing. We're seeing really great wins from very large customers. We think of that product as being a gateway to help with people on their Zero Trust journey. If you think about email, the nature of it is it enumerates the employee directory of an organization, and it helps us sell the other Zero Trust products we have. That conversation is going well. It's also a conversation that is going well in terms of talking to our existing customers. It turns out everybody has a phishing problem. It is for most of our customers, one click to sign up and test whether or not Area 1 can deliver results. We're seeing $1 million-plus wins that close in oftentimes a matter of days or a short number of weeks. We can just prove how successful that is. I think beyond that, Area 1 has helped us in other ways. One, as I mentioned earlier, is that they had a more sophisticated channel program, which has now improved our channel program. I think we're really thankful for that team being on board. The third, which I think you'll hear us talk about more going forward is that they have a world-class threat intelligence team. That can turn into more products across our entire platform. Because I like you, Brent, I'll let you have one more question.

I appreciate that. You've had the crystal ball and everyone appreciates your candor. I think you were the first one to come out and say things are feeling a little different than they felt. I was trying to understand, when you look at the perspective of what's happening now, you mentioned things have stabilized. The stabilization trend that you're seeing, have you seen that extend into July and the rest of the summer? What's your sense of the trajectory as things came in versus where you're at now?

Yes, I received some backlash from my peers at your conference when I mentioned that the economy isn't as optimistic as people believe, and I think many of them are now expressing similar views in Q2. To be clear, the economy remains in a tough spot. I am not an economist, but based on customer feedback, they are still facing challenges. I wouldn’t say that the economy has stabilized. However, we have managed to be flexible in adapting to this difficult environment, which is ongoing and will likely remain challenging for the rest of the year. Our ability to provide products that offer significant value, a strong return on investment, save customers money, and are essential makes us very competitive. As I mentioned earlier, I wouldn’t want to be in any other CEO’s position.

This concludes our Q&A portion of the call. Matthew Prince, I turn the call back to you.

So, I'd like to first of all thank a bunch of the students from the Berklee School of Music for allowing us to use some of their new and original songs for the hope music going in. Hopefully those of you who tuned in the call early appreciated that. I also want to thank the analysts for actually asking Thomas some questions this time. Usually, I get all the questions. Thanks to our team and all of our customers. We've got our hands on the wheel, our eyes on the road, and we'll see you all back here next quarter.

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