Earnings Call Transcript - NET Q2 2025

Operator, Operator

Hello, and welcome to the Cloudflare Second Quarter 2025 Earnings Call. I would now like to turn the conference over to Phil Winslow. You may begin.

Philip Alan Winslow, Investor Relations

Thank you for joining us today to discuss Cloudflare's financial results for the second quarter of 2025. With me on the call, we have Matthew Prince, Co-Founder and CEO; Michelle Zatlyn, Co-Founder and President; 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 uncertainty, much of which is beyond our control. Our actual results may differ significantly from those projected or suggested in any of our forward-looking statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our filings with the SEC as well as in today's earnings press release. Unless otherwise noted, all numbers we talk about today, other than revenue, will be on an adjusted non-GAAP basis. You may find a reconciliation of GAAP to non-GAAP financial measures that are included in our earnings release on our Investor Relations website. For historical periods, a GAAP to non-GAAP reconciliation can be found in the supplemental financial information referenced a few moments ago. We would also like to inform you that we will be participating in KeyBanc's Technology Leadership Forum on August 12, Stifel's Tech Executive Summit on August 26 and Goldman Sachs's Communacopia and Technology Conference on September 9. Now I'd like to turn the call over to Matthew.

Matthew Prince, CEO

Thank you, Phil. We had an excellent quarter. We crossed $2 billion in annual run rate revenue, achieving $512.3 million of revenue in the quarter. We started the year detailing our strategy to drive reaccelerating growth. Our Q2 results highlight that this formula is working and mark a key inflection point for the company, with revenue growing 28% year-over-year, up from 26.5% in the first quarter. We now have 3,712 customers paying us more than $100,000 per year, a 22% increase year-over-year. Revenue contribution from these large customers grew at 35% year-over-year, contributing to 71% of revenue during the quarter, up from 67% in the second quarter last year. Our dollar-based net retention was 114%, up 3% quarter-over-quarter. Our gross margin was 76.3%, in line with our long-term target range of 75% to 77%. We delivered an operating profit of $72.3 million, representing an operating margin of 14.1%, and we generated strong free cash flow of $33.3 million during the quarter, again exceeding expectations. Cloudflare keeps innovating faster than ever, and customers are voting with their wallets. You can see that in the momentum from our Q2 results. It's not just interest; it's real investments that drove record ACV bookings in the quarter. Beyond innovation, under the leadership of Mark Anderson, our President of Revenue, we also delivered significant operational and strategic progress along multiple go-to-market areas in the second quarter. This sets a strong foundation for the rest of the year and beyond. Some highlights of this include the increasing number of ramped account executives year-over-year at the fastest pace in the last two years. We expect growth in our net sales capacity to continue to accelerate in the second half. We delivered another year-over-year and quarter-over-quarter improvement in sales productivity. We again saw particular strength with our largest customers, those that spend over $1 million and $5 million with Cloudflare annually, with both cohorts growing year-over-year at their highest levels since 2022. Finally, new pipeline attainment exceeded our expectations and grew at the fastest rate in more than two years. I once again feel like the company is firing on all cylinders. The momentum you see in these results demonstrates that we have the right technology, the right strategy, and importantly, the right team to accelerate Cloudflare's next phase of growth. That's a good segue to discuss some of our wins in the quarter. A rapidly growing AI company expanded their relationship with Cloudflare, signing a 1-year $15 million pool of funds contract for Workers AI. This is the third contract signed with this customer in the last year as they moved all of their inference workloads from a hyperscaler over to make Cloudflare their single inference cloud platform. The continued expansion with this customer demonstrates not only the tremendous value they realized from the Cloudflare platform, but also the truly unmatched scalability, efficiency, and speed of Workers AI. Cloudflare is increasingly the platform the most innovative companies are choosing to power the future of AI. A Fortune 500 financial services company expanded their relationship with Cloudflare, signing two 3-year contracts totaling $11.4 million for application services and Magic Transit. This customer initially approached us looking to bolster their network resiliency with a dual vendor strategy, and we were happy to come in as the #2 behind their incumbent provider. Impressed with our superior reliability, best-in-class performance, and innovative products in just one month, this customer signed a second contract, making Cloudflare their primary vendor. A Fortune 500 multinational financial services company expanded their relationship with Cloudflare, signing a 3-year $7.1 million contract for application services, Magic Transit, and Workers. This customer turned to Cloudflare to establish greater network resiliency by eliminating any single point of failure, migrating half of their traffic from a long-time incumbent to us. A Fortune 100 global financial services company expanded their relationship with Cloudflare, signing a 1-year $5 million pool of funds contract with initial use cases for Magic Transit, email security, threat intelligence, and application services. In addition to addressing pressing reliability and redundancy requirements in order to improve their network resiliency, this customer also enhanced their security posture and gained unparalleled threat intelligence collected from our vast global network. A large state government entity in the United States expanded their relationship with Cloudflare, signing a 5-year $5.1 million contract for our SASE products, including Secure Web Gateway, Magic WAN, DLP, and CASB. This customer's previous architecture was a mess of multiple vendors, including a first-generation Zero Trust vendor that was only 30% deployed after three years. Consolidating on to Cloudflare's unified platform will improve the customer's overall security posture and simplify their architecture while also realizing roughly 60% cost savings. A Fortune 500 technology company expanded their relationship with Cloudflare, signing a 3-year $2.4 million Zero Trust contract. This deal is notable because we initially lost this RFP 1.5 years ago to a first-generation Zero Trust vendor who was ultimately unable to meet the company's requirements, leading the customer to come back to Cloudflare. They were impressed by how quickly our Zero Trust products had matured in just 18 months. This pace of innovation, combined with our ease of deployment and superior performance, were key differentiators in securing this win this time around. A rapidly growing AI company signed a 5-year $4.6 million contract for AI Gateway, Magic Firewall, Magic Transit, and application services. This highly technical company turned to Cloudflare as a strategic partner to enable accelerated innovation, enhance security, improve performance, and offer unmatched scale with our globally distributed connectivity cloud. This contract is just the beginning with this customer. They're already testing our firewall for AI product. A leading digital travel company expanded their relationship with Cloudflare, signing a 4-year $3.8 million contract primarily for our Workers developer platform. This customer is transitioning workloads from an incumbent hyperscaler to Cloudflare Workers to drive faster innovation and improve global end-user experience. In the words of this customer, 'The performance improvement we saw with Cloudflare was crazy.' This customer is a prime example of our land-and-expand model across our products. They started with DNS in 2023, added application security and performance in 2024, and are now building on our Workers development platform. What's next? They're currently testing our Zero Trust solution. Some of our most strategic customer wins in the quarter, however, weren't big ACV deals. Let me explain. Cloudflare has historically had relatively low penetration in media companies. They didn't spend a lot or have significant security concerns, so they weren't our top priority. However, over the last year, we've gotten to know their senior leaders at many of the leading publishers to understand new threats to their business. Historically, publishers online have made money primarily in two ways: subscriptions or ads. In either case, the key was generating traffic. In the past, one of the most effective ways to do that was through search. Over the last 25 years, publishers allowed Google and other search engines to copy their content in exchange for sending them traffic. But recently, that traffic has been falling dramatically. Based on the data that Cloudflare has observed, it's nearly 10 times harder to get traffic from Google than it was just 10 years ago. What's changed? The interface of the web is switching from search to AI. Even at Google, which has represented the dominant interface for discovering the web, most searches now include an AI overview, which Pew Research has found significantly decreases the likelihood of someone clicking on a link and reading original content. Pew's data aligns exactly with what we've observed based on our customers' traffic. It's even worse with pure AI companies. Every AI company we've tracked shows worse metrics than the Google of old, with some being as much as 30,000 times harder to get traffic from. As the interface of the web switches from search to AI, it's clear more people will read derivatives of content rather than the original content itself. That means the new AI-driven web will kill the old web's business model. Cloudflare is in a unique position to help. More than 20% of the web sits behind us today. But maybe as importantly, around 80% of the leading AI companies know and use us. So in Q2, we partnered with the who's who of the publishing world from the Associated Press to Ziff Davis and nearly everyone else in between to help invent the new business model for content creators on an AI-driven web. The deals we are signing with these companies aren't high dollar, but they are highly strategic. The response has been incredibly positive from publishers for sure, but also from the majority of AI companies who understand that original content is the fuel that powers their engines. When seismic shifts happen in ecosystems as important as the web, new business models inherently emerge. We believe we are uniquely positioned to power the business model of content creation in the coming AI-driven web, but the opportunity may actually be much larger than that. The same rails that we are building to power payments from AI companies to publishers, we believe will also be used to facilitate transactions between AI agents for various online tasks. The fact that we sit in front of so much of the web, and that more than half of our dynamic traffic is already between APIs, means that we are strategically positioned to deliver the agents' web of the future. For those of you who have been following us for a while, you know that we talk about our product areas in terms of acts. Act 1 includes our reverse proxy products, WAF, DDoS mitigation, etc. Act 2 includes our forward proxy products, Zero Trust, VPN, and network firewall. Act 3 comprises our Workers developer tools. What we are doing to help publishers empower agentic transactions is significant enough that we've begun to refer to it internally as Act 4. Now, you may not know this, but I was an English literature major in college with a computer science minor. I read a lot of Shakespeare, and all of his plays had five acts. So don't think we're done here. We've still got a lot more up our sleeves. With that, I'll turn it over to Thomas, our CFO, who thankfully studied economics, not English literature.

Thomas Josef Seifert, CFO

Thank you, Matthew, and thank you to everyone for joining us. At the beginning of the year and again during our Investor Day, we detailed the factors that gave us confidence to drive reaccelerating growth over the course of 2025. We are pleased to have delivered on that goal during the second quarter with revenue increasing 28% year-over-year. As Matthew mentioned, strength in our business this quarter was driven by large $1 million and $5 million-plus customers, continuing our momentum in the enterprise segment, green shoots across the financial services, public sector, retail, and media verticals, and continued momentum with our Workers Developer platform, including Workers AI. In addition to accelerating the net capacity of our sales force, we also delivered another year-over-year increase in sales productivity, improved deal close rates, and exceeded our expectations for new pipeline attainment. Turning to revenue, total revenue for the second quarter increased 28% year-over-year to $512.3 million. From a geographic perspective, the U.S. represented 49% of revenue and increased 22% year-over-year. EMEA represented 28% of revenue and increased 29% year-over-year. APAC represented 15% of revenue and increased 44% year-over-year. Turning to our customer metrics, in the second quarter, we had approximately 266,000 paying customers, representing an addition of over 15,000 paying customers sequentially and an increase of 27% year-over-year. We ended the quarter with more than 3,700 large customers, representing an increase of 22% year-over-year. Revenue contribution from large customers increased to 71% of revenue during the quarter, up from 67% in the second quarter last year. We again saw particular strength in our largest customer cohorts, adding a record number of customers year-over-year spending both over $1 million and over $5 million with Cloudflare, which served as a tailwind to our expansion business. Consequently, our dollar-based net retention rate accelerated to 114% during the quarter, up 3% sequentially and 2% year-over-year. Moving to gross margin, the second quarter gross margin was 76.3%, representing a decrease of 80 basis points sequentially and a decrease of 270 basis points year-over-year. Recall that the extension of the estimated useful life of our network equipment from four to five years at the beginning of fiscal 2024 reduced depreciation for assets in service as of December 31, 2023, by about $5.6 million or 1.4% of revenue for the second quarter. During the second quarter, customer traffic again increased as compared with both the year-ago quarter and the first quarter, resulting in a higher allocation of expenses to cost of goods sold from sales and marketing. At Cloudflare, we've always been clear that our significant cost advantage is a strategic weapon. The accelerating adoption of our Workers development platform is a clear validation of this philosophy, demonstrating how the inherent scalability and efficiency of our network fuels our powerful engine of disruption. Even as we pass on substantial savings to Workers' customers compared with hyperscale competitors, we expect gross margin to comfortably remain within our long-term target range of 75% to 77%. Network CapEx represented 11% of revenue in the second quarter. We continue to expect network CapEx to be 12% to 13% of revenue for the full year 2025. Turning to operating expenses, second quarter operating expenses as a percentage of revenue decreased by 3% year-over-year to 62%. Our total number of employees increased 18% year-over-year, bringing our total headcount to more than 4,600 at the end of the quarter. Sales and marketing expenses were $182.1 million for the quarter, with sales and marketing as a percentage of revenue decreasing to 36% from 37% in the same quarter last year. Research and development expenses were $83.6 million in the quarter, maintaining R&D as a percentage of revenue consistent at 16% in comparison to the same quarter last year. General and administrative expenses were $52.6 million for the quarter, with G&A as a percentage of revenue decreasing to 10% from 11% in the same quarter last year. Operating income was $72.3 million, an increase of 27% year-over-year compared to $57 million in the same period last year. The second quarter operating margin was 14.1%, a slight decrease of 10 basis points year-over-year. Operational excellence is a long-term competitive advantage, and these results highlight our continued focus on becoming more efficient and productive. Moving to net income and the balance sheet, our net income in the quarter was $75.1 million or diluted net income per share of $0.21. Free cash flow was $33.3 million in the quarter or 6% of revenue compared to $38.3 million or 10% of revenue in the same period last year. We feel comfortable with consensus free cash flow estimates for the second half of fiscal 2025. During the second quarter, we issued $2 billion of 0% convertible senior notes due June 2030. In connection with the offering, we also entered into a capped call option transaction with a cap price of 175% over the last reported sale price on June 12, 2025, which protects against dilution to a price of $469.73 per share. We ended the second quarter with $4 billion in cash, cash equivalents, and available-for-sale securities. Remaining performance obligations, or RPO, came in at $1.977 billion, representing an increase of 6% sequentially and 39% year-over-year. Current RPO was 66% of total RPO, increasing 33% year-over-year versus 29% in the first quarter and 30% for the fourth quarter. Turning to guidance for the third quarter and full year 2025. Entering 2025, data gave us confidence to invest to reaccelerate growth. Second quarter results underscore that our strategy of delivering continued innovation and accelerating growth while also remaining committed to the strong unit economics of our business is working, and we are confident in our ability to continue to execute against this winning formula as we transition to the second half of the year and beyond. For the third quarter, we expect revenue in the range of $543.5 million to $544.5 million, representing an increase of 26% to 27% year-over-year. We expect operating income in the range of $75 million to $76 million. We expect an effective tax rate of 20%. We expect diluted net income per share of $0.23, assuming approximately 376.5 million shares outstanding. For the full year 2025, we expect revenue in the range of $2.113.5 billion to $2.115.5 billion, representing an increase of 27% year-over-year. We expect operating income for the full year in the range of $284 million to $286 million. We expect an effective tax rate of 20%. We expect diluted net income per share over that period to be in the range of $0.85 to $0.86, assuming approximately 370 million shares outstanding. In closing, we continue to focus on creating significant shareholder value with our ongoing commitment to disciplined execution, durable growth, and operational efficiency. I'd like to thank our employees for their dedication to our mission and our customers for trusting us to help modernize, accelerate, and secure their businesses. And with that, I'd like to open it up for questions. Operator, please poll for questions.

Operator, Operator

Your first question comes from Keith Weiss of Morgan Stanley.

Keith Weiss, Analyst

Congratulations on a really solid quarter. It definitely looks like the engine is back to running full speed here. I wanted to dig into the business model for the Agentic Web. And maybe, Matthew, you could give us a little bit more color and visibility on what that means in reality. What are the business models that you're looking to enable for your customers? And how do you monetize that for Cloudflare?

Matthew Prince, CEO

Sure. Thanks, Keith. I don't think we know exactly the answer to that. My hunch is that there will be a number of different models that emerge and over time consolidate. The analogy I've been thinking about is risk of hubris. When Apple rolled out $0.99 a song, that was a key turning point in the music industry, but it wasn't the ultimate model that we ended up with. We came closer to something that was $10 a month with Spotify. And so I think that this is going to go through a number of different stages and iterations. You could envision something that is a fraction of $0.01 per transaction. You could imagine different sites charging different things. You could imagine sites that charge agents more or sites that actually discount for agents that are present. I think what we feel confident about, though, is that because a large portion of the internet sits behind us and inherently those agents are going to be passing through us, we have an opportunity to help define what those rails are that the agents will ride on and take some fee from those transactions as we've helped facilitate them and make them faster, more reliable, and more secure. So I think it's too early for us to model exactly what that looks like in terms of revenue. Right now, what we are playing for is very much centered around how do we just get as much adoption as possible? How do we make sure that we are the universal translator regardless of what protocol someone uses, whether it's MCP or the protocol coming out of Google or what's coming out of Microsoft? We want to ensure that no matter what it is, we can work with it. Again, I think we're in a unique strategic position because of how much of the internet already sits behind us.

Operator, Operator

The next question comes from Andy Nowinski with Wells Fargo.

Andrew James Nowinski, Analyst

I extend my congrats as well on a great quarter. So we saw in the news how Cloudflare blocked a number of record-breaking DDoS attacks this quarter. And while your WAF, your DNS and your DDoS solutions are your Act 1 products, they seem to be seeing an inflection just like your newer Act 2 and Act 3 and Act 4 solutions. So Matthew, I also saw on X, that chart you posted about one of those massive attacks that consumed only a few percentage points of your network capacity while it consumed about half your competitors'. So I'm just wondering if you could maybe talk about the Act 1 segment of your portfolio and what's happening there?

Matthew Prince, CEO

Yes. We love the Act 1 products. I think they are probably the easiest way to see the fundamental architectural advantage that Cloudflare has over really everybody else in the space. The way that most of our competitors try to deal with these problems is they set up specific scrubbing centers that have a certain amount of capacity. Those scrubbing centers are not always optimized for the best performance. So traffic is not routed through them all the time. Only when an attack takes place do they switch over. That means that, one, it inherently incurs a cost to route that traffic through. Two, there's intrinsic latency when you switch the traffic over because something needs to change. And, three, those scrubbing centers require limited size on a pure capacity planning basis, maintaining pace with the latest new attacks. We took a very different approach. Every single server that makes up Cloudflare's network is capable of running every single service. That's a significant difference that I think sometimes people overlook. It required a lot more work and engineering to accomplish that. What that then means is that across all of Cloudflare's network, there are no scrubbing centers. Every machine can handle WAF requests and DDoS requests. This means that under normal circumstances, when we're not experiencing a massive attack, far more traffic is flowing out of our network because we're a caching proxy than is flowing in. The way you supply bandwidth is on the greater of in versus out. Unlike anyone else, when we suffer attacks, not only do we have the capacity to handle them, but the underlying cost structure of our business remains unchanged because even with these major attacks, it does not drive up our bandwidth usage. That fundamental architectural change has allowed us to win customers in those Act 1 products. These same architectural benefits also contribute to our wins in Act 2 and Act 3.

Andrew James Nowinski, Analyst

That makes sense. That's very helpful. Maybe a quick follow-up for Thomas. I think you said you surpassed $2 billion in ARR this quarter, which looks like you're still on track to reach that $5 billion target in FY '28. I'm just wondering if you could talk about the path you're on relative to your expectations.

Thomas Josef Seifert, CFO

I would say we are tracking well to our expectations. We were optimistic entering the year when we provided guidance for the year and reiterated during our Investor Day that the signs we are seeing in terms of the progress we are making with our success with large customers, pool of funds deals, variable revenue, and especially the progress the go-to-market team is making in terms of increasing sales productivity and increasing sales capacity overall makes us confident we would reaccelerate this quarter, which serves as a good proof point. A large portion of the performance in the second quarter stemmed from pool of funds deals and variable revenue. We are advancing well with our expectations in this area and can see the positive impact on our dollar-based net retention.

Operator, Operator

The next question comes from Matt Hedberg of RBC Capital Markets.

Matthew George Hedberg, Analyst

I'll offer my congrats as well. Matthew, in your prepared remarks, it was a really good update on some of the go-to-market improvements. It feels like that and it is some of the technology improvements are driving this reacceleration. I guess maybe digging in a little bit more specifically there. How do you think some of these changes are impacting your ability to land larger deals? You gave a number of examples this quarter, and obviously, there was a large deal last quarter. And then maybe as a quick follow-up, could you give us an update on some of the partner momentum? And perhaps is that helping with some of these large deals as well?

Matthew Prince, CEO

Yes. Thanks, Matt. I think that we, for a long time, were very much a product-led growth company, where we let the products stand for themselves, and that was the primary approach we took. As a product-led growth company, you can land big-ish deals, million-dollar deals, but it's really challenging to secure $5 million, $10 million, or even $20 million contracts. Last quarter, we achieved our first $100 million deal. It's been difficult to achieve this solely through product-led growth. I have been impressed by the comprehensive work that Michelle, Mark, and our entire go-to-market team have undertaken to build relationships with buyers, helping them understand the total capability of our platform. When you hear about someone signing up for a pool of funds deal, they're essentially wagering on Cloudflare, betting on our expansive product suite, and placing their faith in our team's continued execution. This ongoing improvement has been noteworthy and hasn't gone unnoticed. In terms of partners, Mark and the sales team have successfully reoriented Cloudflare towards a partner-first sales strategy. You can observe that our growth via the partner sales channel is now outpacing the rest of our business. I don't anticipate reaching the 90% plus seen with companies like Cisco or Zscaler, but I believe we were operating below what would be an appropriate level for us, and that will continue to advance at a rate that surpasses other segments of innovation. I'm dedicating more of my time to engaging with partners, understanding their priorities, and ensuring we can be a valuable partner to them. This has proven vital as we navigate the larger deals going forward.

Operator, Operator

The next question comes from Gabriela Borges with Goldman Sachs.

Gabriela Borges, Analyst

Matthew, I wanted to revisit your comment on pay per crawl, and specifically catalyzing adoption. So talk to us a little bit about what the friction points can be in some of these conversations, particularly conversations with the AI crawlers and the frontier models. And is the decision-maker for an Act 4 type product, the same decision-maker as an Act 1, Act 2 product? How do you build sponsorship across different parts of the organization to catalyze Act 4?

Matthew Prince, CEO

Yes. I was not surprised that publishers were excited about what we were doing. We literally haven't encountered a publisher that's not 100% on board with our proposition. Building those relationships has been amazing. I was surprised by the reaction from the AI companies. I expected they would push back more than they did. Quite the opposite, I think they all fundamentally understand that content, original content, valuable content is the fuel that runs their engines. There are really three legs of the stool that you need to be an AI company: GPUs or TPUs or whatever that may be, and companies like OpenAI reportedly spend over $10 billion a year on GPU access; great talent that understands this new area from a research and scientific perspective, as evidenced by the hiring wars among tech giants; and great original content. For a long time, there has been an assumption that that will be free. In the realm of search engines, that was perhaps permissible, but we aren't building search engines anymore; we're building answer engines. The distinction is that search engines direct you to content for monetization, while answer engines provide answers without requiring you to leave. Therefore, there must be some value creation back to content creators that isn't solely tied to traffic. With a few exceptions, AI companies acknowledge that. This is reflected in comments from major tech firms stating the need to support the ecosystem. The essential point, however, is that a level playing field is critical. It shouldn't be that one company has unique advantages in accessing content. We are focused on ensuring that as the market matures, there are equitable opportunities for all, allowing lesser-known companies to compete alongside established providers. Additionally, we desire to create a structure where smaller providers pay less while larger entities pay more. Ideally, there should be numerous sellers of content and plenty of buyers. If Cloudflare can facilitate that ecosystem, it can be a significant opportunity for us. Regarding buyers for pay per crawl, the answer is either a limited set of AI companies currently or transactions occurring as content is accessed for purposes like training or delivering answers as part of some answer engines. Therefore, this does represent a different transaction type where we feel we have the right relationships and are engaged in the right conversations. My biggest surprise in recent weeks has been AI companies affirming that we need to find ways to support the content ecosystem while ensuring fairness and balance. I believe Cloudflare can play a pivotal role.

Gabriela Borges, Analyst

Yes, makes sense. The follow-up here is on media within the broader construct of publishing, and your comments that this has been underpenetrated in the past. Talk to us a little bit more about how media transitions from being a less attractive vertical for you to a more attractive vertical, particularly given some of your peers have had challenges with renewals in the CDN space, pricing, and negotiations.

Matthew Prince, CEO

I think it may be that this is so strategic we may not prioritize extracting the maximum revenue from media companies. If you assess Cloudflare's business as a whole, investors often question why we maintain a free service. There are numerous benefits that arise from that. It may also turn out that the aggregation of free users on Cloudflare provides more value than the collection of enterprise users. That long tail of content encompasses unique access which, as AI companies endeavor to develop powerful systems reflecting the totality of human knowledge, they need access to those resources. If we facilitate a model where you sign up for Cloudflare and it centers on assisting you in getting paid rather than expecting payment ourselves, that presents a powerful proposition regardless of how much we collect for our Act 1, Act 2, or Act 3 services.

Operator, Operator

The next question comes from Patrick Colville with Scotiabank.

Patrick Edwin Ronald Colville, Analyst

This one is for Matthew. We had a very large foundation model vendor publicly call out Cloudflare as a third-party subprocessor. I thought it was really interesting given the undoubtedly explosive growth we're witnessing in that category in 2025. Not to delve into specifics of that relationship, but can you discuss how Cloudflare can deepen its relationships with foundation model vendors? Which products can Cloudflare sell into these foundation model vendors?

Matthew Prince, CEO

Yes. Thanks, Patrick, for what I think is an intriguing question. As we've said before, our best estimate is that about 80% of the major AI companies are Cloudflare customers today. They use us across a couple of different services, and I'll highlight two. The first is security. The challenge with upholding a foundational model is every time someone makes a request against that model; it results in a genuine cost on your end, often measured in pennies rather than fractions. If someone can find a way to execute requests against your model in a high-volume, uncontrolled manner, or if they find a way to exploit longer credit cards or stolen tokens, those represent unique threats that make partnering with Cloudflare worthwhile for AI companies as we can sit in front. However, we are also finding that with our global network deployment of GPUs, we can facilitate inference in proximity to users. As the efficacy of ChatGPT-like models becomes normalized, the need for optimal performance intensifies. Moreover, given rising global regulations against AI companies, near-user inference is becoming crucial for compliance. Our Cloudflare Workers AI offers the capability to execute inference tasks close to users. For overseeing larger models, we may not be the preferred choice today due to the complexity required, but for smaller models, Cloudflare proves a valuable platform. As we continue to invest, our systems will further accommodate larger models. I believe we are uniquely positioned to provide global-scale inference solutions. If AI companies start with us for security, they quickly recognize the advantages of our Workers products.

Patrick Edwin Ronald Colville, Analyst

Crystal clear. And congrats on that partnership. It's undoubtedly exciting. As my follow-up, can I ask about one of the big news items of the week? Earnings is undoubtedly significant, but the news about Palo Alto buying CyberArk is also noteworthy. Our assumption is that the strategic rationale is for Palo to gain traction in agentic AI security. Could you remind us how Cloudflare evaluates agentic AI security and whether it could potentially impact financial metrics this year or is it more likely a 2026 focus?

Matthew Prince, CEO

Yes. First of all, you cannot dispute that Palo Alto Networks is an iconic company that is excelling in this space. Mark Anderson built much of their go-to-market engine for us, and we have long admired their operational strategy. They have a divergent approach to R&D compared to us—much of theirs hinges on acquisitions, while we're committed to internal innovation. Consequently, when we converse with customers, we often hear that a piecemeal assembly of solutions yields not a comprehensive platform, but a disjointed Frankenstein. This situation introduces security gaps and results in complex and costly stitched-together systems. For us, while we wouldn't rule out future acquisitions, we maintain a stringent threshold for any undertaking, placing precedence on internal innovation and R&D. When we consider our ability to power the agentic web, security naturally plays a significant role. Given that so much of the internet is already behind Cloudflare, those agents will move through us. Thus, establishing guardrails and enforcing rules will be key products that we currently offer, awaiting these systems' evolution. My perspective is that while we are living slightly ahead of the curve, we possess the necessary technology and products developed internally, circumventing the need for an extensive series of R&D acquisitions.

Operator, Operator

The next question comes from Adam Borg with Stifel.

Adam Charles Borg, Analyst

Maybe just for Matthew on Act 2 with SASE. It was great to see you moving into the Visionary Quadrant, Gartner single vendor SASE Magic Quadrant this year, and you talked earlier about a win-back deal that you lost 18 months ago. So maybe just big picture, talk a little bit more about Cloudflare One competitively, what you're hearing from customers, and what you're seeing in the market.

Matthew Prince, CEO

Yes. I think that when we contemplate Gartner and Forrester, our strategy is to get products to market swiftly, collect user feedback comprehensively, and iterate faster than competitors. If our initial entry in those analyses placed us in the top right, we would have delayed the product launch. We are eager to bring services to users and refining them according to their needs. When customers give us the opportunity in this space, we perform well because our services are faster and easier to deploy, providing a superior ROI. When we are included in the competition, we believe we can win. We are reclaiming many former clients and capturing deals from initial-generation SASE and Zero Trust vendors. The limitation we faced previously was primarily awareness and the shift towards a partner-first motion, which Mark and the go-to-market team have now implemented. Our presence in Gartner and Forrester has also increased, and we find ourselves currently neck-and-neck with Zscaler within this market. This growth reflects our progressive company evolution. It reminds me of how, during the introduction of our Act 1 products, analysts doubted we'd ever catch Imperva, the inventor of WAFs, or Arbor. We excel at innovation, and I believe that combined with a fundamental cost advantage will position us competitively.

Adam Charles Borg, Analyst

That's great. And maybe just as a super quick follow-up. Given the 20% of the Internet you cover, you've talked in the past about the crystal ball you possess. Any commentary on the macro that you're observing?

Matthew Prince, CEO

I sense a certain disconnection in the market, with distinct strengths in some sectors while others are struggling. I feel fortunate that despite a somewhat uncertain climate, people continue recognizing the value Cloudflare can provide in terms of business acceleration, delivering genuine security. We continue to perform well regardless of the perspective the crystal ball offers.

Operator, Operator

The next question comes from James Fish with Piper Sandler.

James Edward Fish, Analyst

Nice quarter. But I know we talk about AI all the time, but maybe just shifting off of AI a little bit. Is there a way to think about more of the broader Workers platform directly in terms of how you guys are thinking about capturing workloads that had previously been on a hyperscaler or on-premise versus kind of brand-new workloads? What are you seeing on that Workers core side of things?

Matthew Prince, CEO

Yes. Jim, there are certain workloads that transition seamlessly to our platform. We've discovered that the best method to engage potential clients is not by asking them to transfer an entire application, but rather to suggest migrating one function from their application that's mission-critical or particularly sensitive to latency, allowing us to establish a relationship with them. This initial step enables familiarity with the Workers platform. Once users experience significant reductions in expenses, enhanced performance, and built-in security from that transition, it paves the way for us to explore larger spending opportunities. We've previously noted that our Act 1 products can secure seven-figure contracts while our Act 2 products can reach eight-figure contracts. With our Act 3 offerings, we aspire to capture nine-figure deals, especially as we address workloads that can be extracted from hyperscalers. The way Thomas conceptualizes this is that the most effective way to cement a $100 million deal is to demonstrate that it saves the customer an equivalent amount in what they were spending with hyperscalers. Consequently, this approach drives our ability to capture a more substantial portion of those workloads. Recently, Mark formed a speedboat led by Aly Cabral, who previously managed Workers on the product side. She expressed her desire to dive into the go-to-market aspect, and her team has excelled at hunting specific customers, demonstrating the advantages of transitioning from hyperscalers to Cloudflare, resulting in increased acquisition of those clients.

James Edward Fish, Analyst

Got it. And just as a follow-up, I know you talked about the state win, but we’re beginning to think about the end of the federal cycle here and its impact. What are you observing in terms of FedRAMP, which you've had for a few years? What trends are you seeing that could impact year-end?

Matthew Prince, CEO

Yes. FedRAMP is a priority for us. We're on track to meet all the requirements before the end of this year. Once we accomplish that, we will be unrestricted in terms of the federal business that we can pursue.

Operator, Operator

And the final question comes from the line of Roger Boyd with UBS.

Roger Foley Boyd, Analyst

I wanted to come back to pool of funds. I'm wondering if you could provide more insight into the trends you're witnessing, both from a bookings and consumption perspective. I'd like to understand where we currently stand in terms of offsetting headwinds and tailwinds. It seems more like a net tailwind is emerging; I'd love to hear your perspective. The standout metric for me was a 3-point boost to dollar net retention this quarter. To what degree should we attribute that success to the consumption ramp associated with pool funds?

Thomas Josef Seifert, CFO

Certainly. Pool of funds deals with our largest customers represented low double digits in the second quarter, up from less than 3% a year ago, which is substantial progress. As we mature in this area, we gain more visibility into our tracking. I would state that across all pool of funds deals, we are tracking slightly ahead of targets. One of the results we see due to this is the variable revenue generated from the consumption of existing customers has significantly contributed to our impressive performance in the second quarter, which is reflected in the dollar-based net retention rate. We've previously indicated this rate was bottoming out, and that has occurred. Now with the superior execution on pool of funds and our growing familiarity with this go-to-market approach, we are indeed reaping the tailwinds of this approach.

Matthew Prince, CEO

And Roger, I don’t have anything to add other than I appreciate you asking a question that Thomas could answer, so I wasn’t alone up here on stage.

Operator, Operator

This concludes the question-and-answer session. I'll turn the call to Matthew Prince for closing remarks.

Matthew Prince, CEO

I'm incredibly proud of the entire Cloudflare team and how we've been executing during this fascinating time. Many changes are occurring in how the internet operates, particularly regarding AI. Our role at the center of these significant trends, shaping the future, excites me about Cloudflare's prospects more than ever. Thank you to the entire team. Thank you to our customers. We'll see you all back here next quarter.

Operator, Operator

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