Cloudflare offered a solid earnings report, yet the valuation is extraordinarily high, thus, the company really needed to report a blowout to justify the valuation (which did not happen). It’s good to see Cloudflare report steady growth, however, and its key metrics supporting sustained growth as we patiently wait for Cloudflare to lead in AI inference at the edge.
There is a quiet strength in Cloudflare’s fundamentals and key metrics. For example, Cloudflare passed a $2B run rate for the first time, signed their first $100M deal, dollar-based net retention (DBNRR) seems to have bottomed along with a slight 1.3% acceleration in revenue. Regarding the bottom line, Cloudflare is certainly stronger than many cloud peers yet tends to walk a razor’s edge due to capex.
Regarding AI inference, for the Workers Platform known as Act 3, management connected some important dots on the earnings call as to why agentic AI will drive forward the massive inference trend. The I/O Fund team recently dug up a stat inference is expected to account for 60% to 70% of AI workloads by 2030. In particular, Cloudflare emphasizes their position is what will help the company win this market: “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 agentic web of the future.”
Cloudflare also introduced Act 4 – a new product that will help AI search engines connect with (and potentially) pay publishers for using derivatives of their copyrighted works. Although the amount of demand for this and exactly how Cloudflare will monetize this new product is not clear, it is interesting management feels confident enough to call the new use case its fourth act.
Given Cloudflare’s valuation, the entry is probably the most important aspect of this stock right now – whereas in the medium to long-term the most important aspect is timing for the broader inference market.
We’ve covered Cloudflare’s thesis and Acts 1, 2, and 3 in the analysis “Bringing AI Inference to the Edge” and repeated some of the key aspects later in an earnings update, “Cloudflare: Entering Act 3 to Become a Leader in AI inference at the Edge.”Bringing AI Inference to the Edge” and repeated some of the key aspects later in an earnings update, “Cloudflare: Entering Act 3 to Become a Leader in AI inference at the Edge.”
Cloudflare Raises FY25 Revenue Growth to Nearly 27% After Largest Beat in Six Quarters
Cloudflare reported its largest revenue beat in the last six quarters at 2.1% above consensus, with Q2 revenue up 27.8% YoY to $512.3 million. This also marked a slight 1.3 point acceleration on the top-line from 26.5% growth in Q1.
For Q3, Cloudflare guided for revenue of $543.5 to $544.5 million, ahead of estimates at the time for $538.9 million. This corresponds to a slight deceleration to the mid-to-high 26% YoY growth range, where Cloudflare is expected to remain through Q4. This provides no clear indication yet that the company is able to drive a sustained revenue acceleration aided by AI.
However, not even three weeks from the report, the Street is already getting more optimistic and is now expecting a stronger Q3. Consensus estimates are now above the high-end of management’s guidance at $544.9 million, essentially already pricing in stronger momentum fueling a beat for Q3 despite how early it is in the quarter.
For the full-year, Cloudflare raised its outlook to $2,113.5 million to $2,115.5 million, for YoY growth of 26.7%. This is a $22.5 million increase at midpoint from Cloudflare’s prior outlook for $2,090 million to $2,094 million for growth of 25.3%.
DBNRR Inflects 3 Points to 114%, Paying Customer and cRPO Growth Remains Strong
Cloudflare also showed strong key metrics in Q2, maintaining strong growth in paying customers and billings while DBNRR more meaningfully inflected.
Paying customers increased 27.5% YoY to 267,929 in Q2, the second quarter in a row with 27%+ growth. This is a notable improvement from 17% and 21% growth in Q1 and Q2 2024. Cloudflare stated that it added a record number of customers YoY spending over $1M and over $5M.
While Cloudflare noted that its largest customers are growing investments at the highest levels since 2022, growth in its large customer cohort ($100K+ ARR) is decelerating. Cloudflare reported 22% YoY growth to 3,712 $100K+ ARR customers in Q2, decelerating slightly from 23% in Q1 and 30% in the year ago quarter. This cohort accounts for 71% of revenue, up from 69% in Q1 and up from 67% in the year-ago quarter.
Billings increased 33% YoY to $559.2 million, a third straight quarter with growth above 30% YoY.
RPO increased 39% YoY and 6% QoQ to $1.98 billion.
Current RPO accounted for 66% of total RPO, or ~$1.30 billion, increasing 33% YoY in Q2, a four point acceleration from 29% growth in Q1.This is also a notable uplift from 26% growth in the year ago quarter.
Aided by strength in its >$1M customer cohort, which management said served as a tailwind, DBNRR more meaningfully inflected in Q2 to 114%, its highest level in more than a year.
Quick note on Pool of Funds:
We previously covered pool of funds here, explaining that pool of funds accounts are unique to the largest customers (for example, 4 of the top 10 customers are this account type) that use many products across the entire Cloudflare platform. These are considered larger platform deals that are paid on a monthly basis in a multi-year contract rather than an annual contract on one product. For some time, this shifted how DBNRR and RPO were reported since revenue is recognized as the customer consumes the service.
The current update (albeit a bit vague) is that “pool of funds deals with our largest customers represented low double digit in the second quarter, up from less than 3% a year ago. So significant progress.”
GAAP Margins Drift Lower
Gross margins drifted lower in Q2, driven by both an increase in depreciation expenses and in allocated costs from higher network traffic from paying customers. GAAP operating margins followed, moving further away from reaching break-even.
Cloudflare had an interesting comment on long-term margins, stating that it expects to remain comfortably in its 75% to 77% adjusted gross margin target despite passing on substantial savings to Workers’ customers. This suggests that upside to operating margins will be driven by expenditures, such as moderating higher sales & marketing spending, at 36% of revenue versus its target range of 27-29%, and high SBC at 24% of revenue.
- GAAP gross margin was 74.9% in Q2, down nearly 3 points YoY and 1 point QoQ. Adjusted gross margin was 76.3%, down 2.7 points YoY and 0.8 points QoQ.
- GAAP operating margin was (13.1%), down 4.4 points YoY and 2 points QoQ. Adjusted operating margin was 14.1%, approximately flat YoY and up 2.4 points QoQ; this was also ahead of guidance for 12.6%.
- For Q3, Cloudflare guided for adjusted operating income of $75-76 million, pointing to adjusted operating margin of 13.9%, down nearly 1 point YoY and moderating slightly QoQ.
- GAAP net margin was (9.8%), down 6 points YoY and 1.8 points QoQ. Adjusted net margin was 14.7%, down 2.6 points YoY but up 2.5 points QoQ.
FY25 EPS Raised Slightly
Cloudflare topped estimates in Q2 driven by the revenue beat and stronger adjusted margins, and boosted its FY25 adjusted EPS outlook as a result.
- GAAP EPS was ($0.15), missing estimates for ($0.08) as GAAP margins drifted lower.
- Adjusted EPS was $0.21, beating estimates for $0.18, fueled the outperformance in adjusted operating margin in the quarter.
For Q3, Cloudflare guided for $0.23 in adjusted EPS, a slight uptick sequentially, while for FY25, the company raised its forecast from $0.79-$0.80 to $0.85-$0.86. This corresponds to growth of ~14.5% YoY, up from the mid-6% range previously. Growth is expected to be much stronger in FY26 at ~30% YoY to $1.12.
Cash Flow Margins Contract, and Cloudflare Raises $2B in Convertible Debt
Cash flow margins contracted sequentially, while Cloudflare significantly bolstered its cash pile after a large convertible note issuance.
- Operating cash flow was $99.8 million for a 19% margin, flat YoY but down from a 30% margin in Q1.
- Free cash flow was $33.3 million for a 6% margin, down 4 points YoY and 5 points QoQ.
- Network capex was 11% of revenue in Q2, down from 17% of revenue in Q2. Cloudflare stuck to its guidance for network capex to be 12-13% of revenue for the year, suggesting slight moderation in 2H.
- In June, Cloudflare raised $1.97 billion in new convertible notes due 2030, raising its cash on hand to $3.96 billion while convertible notes outstanding rose to $3.26 billion.
Earnings Call Q&A:
Agentic AI & Small Language Models (SLMs) is where Cloudflare’s AI impact will become more apparent
Today, AI agents are mainly LLM-based copilots and assistants rather than truly autonomous agents. The broader vision is for agents to set goals and act without a human prompting each action. Gartner is a reasonable forecaster and is placing 2027-2028 as the time frame when 33% of enterprise software apps will include agentic AI.
While large language models will continue to provide the more complex reasoning tasks, small language models will be deployed to execute the day-to-day automation with major benefits over LLMs such as being quicker and cheaper when running thousands or millions of decisions per user. The major difference is that LLMs are massive knowledge engines whereas SLMs are run locally and offer speed.
That’s a critical distinction to make when listening to Cloudflare’s management talk about why their stock has not performed as well in the LLM phase of AI versus the upcoming SLM phase:
“We would not be today the right place for one of the really massive LLMs to run because those, in many cases, will require multiple different machines working in coordination. It is a more complicated task. But for smaller models, we're finding that Cloudflare is the best place for anyone who's building that to run that. And over time, we are investing in making our systems able to support larger and larger and larger models.”
In addition, Cloudflare represents 20% of the internet and that number is in the mid-30% when considering the top 10,000 sites. By managing a leading percentage of internet traffic, agentic AI will route through Cloudflare’s reverse proxy and CDN to fetch data and trigger APIs. The company offers Cloudflare Workers and WebAssembly for a low-latency and distributed hosting environment to run SLMs. Additionally, agentic AI will require enhanced security since autonomous actions can have a larger impact from errors (bad API calls) or security issues that are more malicious.
This is how management discussed it on the earnings call:
“I think what we feel confident, though, is that because of the fact that so much of the Internet sits behind us and inherently, those agents are going to be passing through us that we have an opportunity to help define what those rails are that the agents will ride on and take some fee from that — those transactions as we've helped facilitate them and make them faster, more reliable, more secure, give people the access to those rails.”
Act 4 Seeks to Minimize the Impact AI has on Publishers
Cloudflare recently launched a product that prevents AI bots from accessing websites without payment. It’s no secret that AI has made a dramatic impact on publishers given AI-driven search tools do not refer traffic to the sources they scrape data from. Whether it’s OpenAI and Microsoft getting sued by The New York Times or stats like this one that publishers are seeing 25% fewer referral clicks, the evidence is mounting that AI is destroying business models for both smaller, independent publishers and larger media conglomerates.
Cloudflare had some wild statistics on their call, stating “based on the data that Cloudflare has observed, it's nearly 10x harder to get traffic from Google than it was just 10 years ago.” Even more crazy, they stated “every AI company we've tracked is worse than the Google of old with some being as much as 30,000x harder to get traffic from” – likely referring to OpenAI or Anthropic.
This is one to watch as it could become one of Cloudflare’s fastest growing products given the pain point Act 4 seeks to solve.
“But we aren't building search engines anymore. We're building answer engines. And the difference between a search engine and an answer engine is a search engine directs you to that content where you can go and the content creator can monetize it. An answer engine answers without you having to leave. And so there has to be some value creation back to content creators that isn't just based on traffic.”
You can read the official Pay per Crawl announcement here.
Valuation is high
Cloudflare trades at a forward PS ratio of 28.5. The exuberant investor will tell you that any contribution from AI demands a higher valuation than what we’ve seen in the past, yet time will tell if that is true. We prefer to see if we can get Cloudflare and really any cloud stock under 20 forward PS. Typically, Cloudflare at a 15 forward PS is a great spot to buy.
Conclusion:
As of now, we are patiently waiting to get Cloudflare lower ahead of the inference market taking off. Remember – our thesis is about Cloudflare’s positioning, which is multi-faceted in terms of how Cloudflare can monetize its AI utility at the internet infrastructure level. As agentic AI and SLMs become a leading paradigm, Cloudflare’s network is set to become a critical player. You’re seeing some of this with Cloudflare able to seamlessly pivot toward helping publishers get paid by Big Tech, which is typically a cutthroat group. The company is also effortlessly expanding its use case for AI inference to include agentic AI and SLMs; meaning no matter where AI development takes inference, Cloudflare will be there.
Since our firm likes to be prudent, margins are not actually bulletproof as Cloudflare is not GAAP profitable and margins contracted this quarter. This line item has a red mark on our checklist, and we will continue to look at this closely in the coming earnings reports.
Damien Robbins, Equity Analyst at I/O Fund contributed to this analysis.
Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund do not own shares in NET at the time of writing and may own stocks pictured in the charts.
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