Cloudflare, Inc. Q2 FY2024 Earnings Call

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. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. I would now like to turn the call over to Mr. Phil Winslow. Please go ahead.

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. We would also like to inform you that we will be participating in the Stifel Tech Executive Summit on August 26th and the Goldman Sachs Communacopia and Technology Conference on September 10th. Now, I'd like to turn the call over to Matthew.

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 had to fight for every deal as the IT-buying environment continues to be challenging. But our investments in go-to-market improvements are showing dividends. It 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 and 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 two-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, worker serverless development, and bot management. Over the next two 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 three-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 solution, network performance, and future roadmap. 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 five-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, email 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're 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 two-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 one-year $895,000 contract for Magic Transit and Magic Firewalls. Gaps in their incumbent products with two on-premise tenders left this customer vulnerable to attacks, creating significant urgency for our placement solution. A number of channel partners mentioned Cloudflare as a leader in DDoS to this customer, and we were quick to come in and get this customer fully deployed, operational, and protected in just 10 days. A Fortune 500 gaming company signed a two-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 through 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 one-year $500,000 contract with Cloudflare to be their platform for AI for inference, storage, image optimization, and application security. This company, with an existing R2 customer, allows 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 inference tasks 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 two-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's broader platform and signing a pool of funds 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, a over 20% increase in just the last four 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 right behind 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 meddle. 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 goals to walk through our financial results. Thomas, take it away.

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 uptick 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 had 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 reduce friction to adoption across our product portfolio, that 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 anniversary in the price increase to our Pro and business PayGo 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 the 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 greater efficiency across our operations. Our total number of employees increased 15% year-over-year, bringing our total headcount 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 of our go-to-market organization to focus on more stage-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 the 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 dilutive 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 million, 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 million to $1,659 million, 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 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.

Thank you. We will now begin the question-and-answer session. Your first question comes from the line of Matt Hedberg of RBC Capital Markets. Your line is now open.

Great. Thank you very much, guys. Congrats on the quarter. Obviously, this is a challenging environment, and to see the consistency, it's really great. Matthew, maybe to start with you. It was great to see another 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 given that you said macros remain challenging, is increased productivity also helping the cause of really accelerated sales cycles and improved close rates?

Yes. Thanks, Matt. I think we've tried to be very transparent about what we were seeing. I think the real low point 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 mid-2022. So we’re rebounding well. I think Mark Anderson gets a lot of credit for that over the last bit, but the real changes started even before Mark joined us. And I think we're starting to see the benefits of the changes of just really putting in place much better operational metrics, putting in place much better training, really elevating 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. So Mark has a huge number of amazing people who want to follow him. Those people who follow him now are bringing in and uplifting our team. What we're seeing is not only are they more productive, but they're helping our existing team, who are really amazing people, get more productive as well. So I think discipline and execution started before Mark Anderson and I think it's accelerating with him. We have never had a product problem. We've never had a 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 sell what is an incredible product.

That's great. It sounds like a real flywheel effect. And maybe just a quick one for Thomas. In your prepared remarks, you noted that DNR ticked down three 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?

Yes. So as we said in my prepared remarks, the decrease was driven by slower net expansion, but it was also impacted by what Matthew described, a large pool of funds deals. So as we enter this fiscal year, we've entered into several of these pool of fund deals. They're all very large in nature, the biggest ones, anywhere between $40 million to $60 million of total contract value. In fact, four of our top 10 customers are now pool of funds customers. And these pool of fund deals are generally billed monthly compared to an upfront annual billing and they tend to have longer duration. Most of these contracts are over three years. The financial impact of these pool of fund deals is very different. It impacts revenue and it's different on current RPO and deferred revenue. If it's an existing customer that transitions, it also impacts DNR. As it relates to revenue, the revenue is recognized as the customer consumes the service, and as a result, the revenue recognition might be non-linear and might ramp over time because those deals have monthly billing terms; we do not report upfront deferred revenue, resulting in lower deferred revenue growth. So while 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, but they are very healthy developments nonetheless. They will make the business a little bit more lumpy. I still think those KPIs are the right KPIs, but I think you have to look at them more from a rolling and average perspective.

Super helpful. Thank you.

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

Thank you. Good afternoon and congrats on the results in what appears to be a swift action by Mark and the entire team. Matthew, given the recent CrowdStrike ID outage, which was predominantly on-premise, 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.

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 team offered to help CrowdStrike directly in any way that we could, helping them get patches or leases out, assisting in reviewing 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 his leadership team. I think more generally though, the word of the day is resilience, which is that customers are going to want to make sure that they are not reliant on any one vendor, and that includes vendors providing network security like we do at Cloudflare. When we're talking to large financial institutions, they're telling us, we want to use you and someone else. That's going to put pressure on some of the older, more legacy providers. It opens up more opportunities for us over time. What I'm hearing from customers is that resilience is key and that people are increasingly not wanting to be entirely reliant on any one vendor. I think that especially in the larger accounts we're targeting, this will 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 time and time again when you put us next to anyone else, in the CASB space, SASE space, we may start out as the number two vendor, but they quickly realize that we should be number one.

Understood. I was listening carefully to your prepared remarks related to the product; it seems as if you're hitting on all cylinders—Magic Translate, Virtual Firewall, SASE workers, you name it. My question is whether there was any specific one or two product services that stood out specifically this quarter?

The first thing I'd say is that when we say people are signing up for pool of funds deals, what they are really signing up for is to use the entire Cloudflare platform. More and more, we're seeing that people are choosing us not for one feature or another. I'm picking it because the entire platform gives me a solution to all of my network performance, security, and reliability needs. If you force me to pick one area that's really standing out, it's the developer platform. I was blown away that just quarter-over-quarter, we've seen a 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 get the latest versions out on our platform, and developers are just flocking to it. I think that if you look around in our developer channels, our Discord channel, and on Twitter, you'll see that more and more developers are betting the future of their applications on the Workers platform. If you force me to pick one thing, I'm going to say Workers was the real standout of the quarter, but generally, it’s been the platform.

Thank you. Well done.

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

Hey, guys. Thanks for the questions here. Look, I know it's not a metric you completely focus on, but it was the largest net customer additions I think you've had as a public company in aggregate. Matthew, you've had a phenomenal track record of really calling out IT spending trends, and you did say some tightness still. My question is, how are customers balancing this tightness with potential total cost of ownership savings by moving on to a Cloudflare versus new projects? How are you 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?

Yes. 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 the name of the game here. Increased execution will pay dividends even as the IT environment does rebound over time. Our crystal ball still shows that it's challenging 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 and productivity tech, I think security is one of the areas where people are continuing to invest. What’s powerful about Cloudflare is we don’t just solve one security need; we solve the totality of a customer's security needs. Oftentimes, when a customer is signing one of these pool of fund deals, they're replacing two, three, or four different vendors and consolidating behind Cloudflare. We want to own the network security space as that’s the area where we can provide solutions for customers. In tough IT budgets, they tend to want to consolidate on a single vendor, and we are a beneficiary of that.

I just wanted to add to your introduction that it was a very strong net customer quarter, mainly driven by three effects. We had a one-time benefit because we migrated billing platforms, so there was a catch-up. Beyond that one-time benefit, it was a very strong quarter driven by our two-customer increase, up 32% quarter-over-quarter, as well as the increase in developers on the Workers platform that Matthew talked about. Those three factors were driving the growth—very strong quarter.

Makes sense. You guys obviously have a pool of funds as another theme of this quarter. Thomas, you had just said a few moments ago that four of the top 10 customers are now on this type of contract. Is there a way to understand how much of RPO is now on this sort of pool of funds path? Even just those four at that kind of $50 million average rate would imply about 15% of RPO today. Additionally, what could that look like in a few years down the road?

I won't give you that kind of information. But what you just said, I think is a good indication. We've always been asked how we drive customer revenue up and how we can get to three-digit million ACVs and TCVs. Pool of funds will be that path, and Matthew outlined the reasons for that. In addition to the pool of fund deals, in the second quarter, we entered into a handful of very large subscription arrangements, all well north of $5 million. These are more predictable from a revenue recognition and forecasting perspective, but they have similar impacts on RPO and deferred revenue as well. The pool of fund structure impacts us and generates some lumpiness this quarter, but we also signed very large subscription arrangements in the second quarter.

Great. Thanks, guys.

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

Okay, good afternoon. Congrats on another amazing quarter. I wanted to ask a tech question regarding your Edge AI and your OHTTP offering. I know you're one of the co-founders of OHTTP, but I was wondering if you could comment on how your customers might be using it to preserve data privacy and give us an idea on the revenue opportunity there?

Sure. I’m not sure how to explain this without getting a little geeky. OHTTP aims to disassociate your IP address from your identity, which is important as privacy is increasingly recognized online. OHTTP, essentially does this via two hops in the system. If your device connects to the first proxy, that proxy knows what device connects to it, but it can use encryption to hide that identity piece from the second proxy, which is the only one that knows where the traffic is going. One party knows who is behind something, and the other knows where they're going, but neither knows both. It required an independent third-party, and that third-party will need to be Cloudflare. This reflects how critical privacy is to our functionality and the future market for this type of solution. As AI develops, many will rethink internet privacy and incorporate more modern standards. OHTTP can help reach that intention and yield revenue in the future.

Great. Thank you. 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. 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?

Yes, nice try, but I'm not going to give guidance for next year. Over the years, we have been good stewards of investors' capital, and this will continue. Matthew and Michelle described how we run the business really well in this long-term growth rate. We see a big market to disrupt and deliver strong growth rates; investment into Cloudflare is the best return for the money that we earn. Keeping the balance in terms of how we think about the business of growth rate and operating leverage will serve us well, and we won't deviate from this philosophy next year, but I will shy away from giving you guidance.

Okay, thanks. Keep up the good work, guys.

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

Awesome, and thanks for taking the question. 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've built as well as the Edge device themselves? How do you think about how that relationship looks today and how that evolves over time?

Yes, Adam. Inference will primarily happen in two places. First is on devices themselves—many device manufacturers are already bringing more powerful GPUs and TPUs onto devices. My rough estimate is that maybe 50% of inference tasks will be handled on your device. The other 50% of inference tasks will be sent to either traditional centralized public clouds or to a network like Cloudflare. Because of privacy concerns and regulatory requirements around AI, you will see a lot of inference tasks being moved to the closest network possible, and that's what we're building. We want to ensure that we can answer any inference task that can't be determined on your device, as close as possible to that device. We are trying to build out that network ahead of demand to ensure that we’re available for all inference tasks, and we are well positioned relative to others in the hyperscale space.

Awesome. Thanks so much.

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

Good afternoon. Thank you for taking my questions. Matthew and Thomas, this is for you both. I had a big-picture question around the pricing strategy across the portfolio. At a tactical level, you had meaningful price increases that were your first ones ever. Thomas, wondering if you could opine on how far deep those have penetrated the installed base and if you can kind of talk to where we are in terms of the innings, as it relates to how that unfurled in the base? And then, Matthew, the bigger picture question for you is if I put together a lot of what you shared in the prepared remarks as it relates to pool of fund deals, more pay-as-you-go, and 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? Thank you.

I'll start, then Thomas can add. We're about a year past a price increase across our pay-as-you-go business. It's an important part of our business, but it is relatively small. For a long time, we were very reluctant to raise prices on that part, but we had added so much value that it felt right. We were pleasantly surprised how many pay-as-you-go customers not only didn’t leave but even said, 'About time; there's so much more value.' Price increases didn’t apply across the rest of the platform, so enterprise customers didn’t see any dramatic increases. We always look for ways to have the highest ROI for our large customers. We think we're typically a substantial saving over what the existing vendors are in the market. Our efficiency allows us to maintain 78%-79% gross margins. We want to be the connectivity cloud for our customers and solve all their problems. It’s a substantial opportunity that I think we have only just started to penetrate.

There's not much to add to what Matthew just said. Some of the impacts of this transition are the noise that we observed, and we talked about how pool of funds deals impact the lumpiness or make our numbers a little bit more variable. We have an increasingly higher share of variable revenue in our numbers, although it’s still small today, but it will grow meaningful over time. This growth is driven less by the price increases, and more by the structural changes that this transition implies, providing platform deals with better expansion capability and significantly higher total contract values.

Thank you for the color.

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

All right. Good evening. Thank you for taking my questions. Matthew, I just have one question on the public sector for you. We saw a lot of strong momentum in the public sector space and 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? Thank you.

Federal business has been a real point of strength for us ever since we started investing in it. 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 that the election is incredibly important. Since 2016, we launched what we call the Athenian project, providing our services at no cost to anyone helping administer an election in the United States, and we've increasingly started doing this in select countries. I'm proud of our work on this to help support those administering elections; they are heroes and need our help. The election doesn't necessarily drive significant upticks in spending. Still, public servants I've talked to across the political spectrum respect companies like Cloudflare that step up to protect democracy. This dedication is reflected in our momentum and success with federal business, and I think it will continue and accelerate over the years to come.

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

Great. Hi, team. Thanks for taking my question. Maybe just one question for me, but I need a couple of parts. Matthew, you had a good win story in your prepared remarks about an Australian tech company signing a deal where they also purchased Workers. How much are you leaning into those SASE deals where an act 3 product such as Workers is coming into the fold, and how important a differentiator do you see that within that particular market? On a follow-up, you had your disaggregator campaign last year to handle a competitor in that space. Just curious if you’re seeing that overall competitive landscape shift at all in the last 12 months, and if we might see a similar campaign against another competitor there? Who are you seeing in the deals, and if there are any other unexpected players coming up from different parts of the market?

We are offering comprehensive solutions that point solution vendors can't match. When we say pool of funds platforms, that's our broad platform that includes SASE and Workers. It's critical to have both network security and traffic management addressed by the same vendor. We don't yet have any real vendor claiming to separate themselves with Workers. Customers are using Workers with SASE to achieve comprehensive network solutions. SASE as a category is still new. Over time, as customers move from seeking secure, reliable, fast networks to needing them to be programmable, I believe we will be well-positioned. Currently, customers are coming to us away from first-gen zero-trust and legacy SASE companies because we offer them a superior solution.

Great. I appreciate the perspective. Thanks.

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

I just wanted to say thank you to the entire Cloudflare team. This quarter really had the theme of 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, but Cloudflare is helping better secure networks everywhere around the world. Thank you all. See you back here next quarter.

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