Alibaba's profits declined by 75% as its quarterly expenditures on AI reached $10 billion.

      Alibaba's net profit dropped 75% in the June quarter, totaling $1.54 billion. This decline was not due to poor business performance but rather the expenses related to business expansion. Capital expenditures reached $9.98 billion in three months, a 75% increase compared to the same quarter last year, according to the results announcement. In the same financial report, the cloud division that incurred this spending reported a segment profit increase of 133%.

      Revenue rose by 9% to $39.64 billion, slightly surpassing the LSEG consensus of RMB 268.88 billion, according to CNBC. However, free cash flow went in a different direction. The company recorded a cash outflow of $6.58 billion, compared to an outflow of $2.77 billion during the previous year. Following this news, Alibaba's shares in the U.S. dropped by approximately 5% after the market opened.

      The cloud segment is performing well. AI Cloud and Compute Services generated $7.14 billion, representing a 45% year-over-year increase. This marks the fastest growth for the division in 22 quarters, as calculated by the South China Morning Post. Revenue from AI-related products within this segment reached $1.82 billion and has seen triple-digit growth for the twelfth consecutive quarter. The unit also turned a profit, with adjusted EBITA reaching $830 million, reflecting a 133% increase. Chief Financial Officer Toby Xu reported the cloud segment's EBITA margin at 12%. According to Alibaba, its cloud service holds a dominant 38.1% share of China's AI cloud market, based on research from Omdia.

      There is a caveat regarding these comparisons. Alibaba reorganized its reporting segments this quarter by integrating the chip division T-Head into the cloud business and transferring its model labs and consumer AI applications into a new segment. Year-on-year figures have been adjusted to ensure consistency, but the segments differ from those analysts previously modeled.

      The company cited three reasons for the increase in capital expenditures. First, procurement cycles varied. Second, it added CPU-compute capacity in anticipation of demand for AI agents. Third, the prices of various chip components rose, impacting firms across the Chinese hardware sector this quarter.

      This spending is what led to negative cash flow. Property and equipment purchases totaled $9.97 billion, while operating cash flow was only $3.38 billion. This pattern mirrors what occurred at Meta last quarter, where AI capital expenditures created a cash-flow issue, while Microsoft transformed similar spending into cloud revenue. Alibaba is attempting to manage both aspects simultaneously.

      The new AI Labs and Applications segment encompasses model labs, the Qwen consumer app, and the QwenWork agent, generating $492 million in revenue, a 16% rise. However, it recorded a loss of $2.04 billion at the adjusted EBITA level, compared to a loss of $475 million a year prior. The company attributed this loss to investments in AI and the costs associated with running the inference for the Qwen app.

      Alibaba is not the only company facing challenges. Tencent recently more than doubled its own AI expenditures, unsettling investors in the process. Analysts took note of this situation as well. Citigroup remarked that increasing capital expenditures and negative free cash flow "could raise concerns around capital needs and investment returns." Bloomberg Intelligence made an even more pointed observation, stating that AI would "continue to depress, not enhance, returns" for leading AI companies in China, predicting cash losses for Alibaba's AI business over the next three years.

      In response, CEO Eddie Wu presented a contrasting view during the analyst call. He argued that the AI business's ability to self-fund and maintain viability is improving, bolstering confidence in further investments. He noted that AI has become the company's most promising growth engine. Wu provided quantitative backing for this claim, estimating that annual revenue from AI products should reach approximately $10 billion this quarter, up from about $7.3 billion in the previous quarter. Executives are optimistic that the company will recoup its total AI investments within the three-year timeframe established in early 2025, when it pledged over RMB 380 billion.

      The headline figure of a 75% drop also supports the argument against the company. Non-GAAP net income, excluding share-based payments, investment fluctuations, and impairments, decreased by 38% to $3.05 billion. Adjusted EBITA of $4.03 billion exceeded expectations. While Nikkei interpreted the quarter as missing projections, the South China Morning Post viewed it as beating them, highlighting different perspectives on the same financial statements.

      One figure that went unnoticed in the day's analysis was the increase in general and administrative expenses, which rose to 4.7% of revenue from 3.0%. The company explicitly stated that this increase was due to a provision for the €550 million fine imposed by the European Commission for the Digital Services Act. This penalty was levied