Thinking of Buying Alibaba Stock Now? Here's 1 Green Flag and 1 Red Flag.

Alibaba (NYSE: BABA) is changing.

For years, investors knew the company primarily as China's e-commerce giant, with Taobao and Tmall at the center of its business. But Alibaba is now pouring billions of dollars into artificial intelligence (AI), building cloud infrastructure, developing its own AI models, and even investing in AI chips.

The transformation is starting to show up in the numbers.

In its fiscal 2027 first quarter, which ended June 30, Alibaba's AI cloud and compute services revenue jumped 45% year over year to 48.4 billion yuan (about $7.2 billion). But there's a catch: Capital spending surged 75% to 67.7 billion yuan ($10.1 billion), pushing free cash flow into negative territory.

So, is Alibaba a buy now? Investors should focus on one major green flag and one red flag.

Image source: Getty Images.

Green flag: AI is becoming a real business

For years, Alibaba's AI ambitions were mostly a promise.

The company had Qwen, its family of large language models. It had Alibaba Cloud. And it had ambitious plans to invest heavily in AI infrastructure. But investors still needed proof that businesses would actually pay for these services.

That proof is beginning to emerge. Alibaba's AI cloud and compute services revenue grew 45% year over year in the latest quarter. That's impressive growth for a business already generating billions of dollars in quarterly revenue. Even more encouraging, adjusted earnings before interest, taxes, and amortization (EBITA) for the segment jumped 133%.

In simple terms, Alibaba isn't just getting more customers to use its AI services. It's also starting to make more money from the AI business as it grows.

That's important because cloud computing can become more profitable as infrastructure gets used more efficiently. Once the expensive data centers and computing systems are in place, additional revenue can flow through at higher margins -- an effect enabled by operating leverage.

Alibaba is also building an ecosystem around Qwen, its AI model family. Developers can use Qwen to build their own applications, while Alibaba provides the computing power and software tools needed to run them.

Think of it this way: Qwen attracts developers. Alibaba AI Cloud provides the infrastructure. If that flywheel continues to work, Alibaba could build a much larger and more valuable cloud business over time.

And there are already signs that this is happening. Alibaba said AI-related product revenue has grown at triple-digit percentage rates for 12 consecutive quarters, while Alibaba Cloud ranked first in China's AI cloud market, with a 38.1% market share.

For investors, this is the most encouraging part of Alibaba's transformation. AI is no longer just an investment story. It's starting to become a profit story.

Red flag: The AI opportunity doesn't come cheap

Here's the problem.

Alibaba is spending an enormous amount of money in pursuit of the AI opportunity.

Capital expenditures jumped 75% year over year to 68 billion yuan ($10.1 billion) in the latest quarter, and free cash flow turned negative. In other words, Alibaba is spending heavily today in the hope of generating much larger returns tomorrow.

While the conglomerate has historically relied on profits from its flagship e-commerce business to fund these investments, it may eventually turn to external funds for two reasons.

First, the e-commerce business itself is burning huge amounts of profits to expand into the instant commerce segment. While there are signs that this investment period is nearing its end, as evidenced by the recovery in its EBITA, there is no guarantee that Alibaba won't ramp it back up in the future.

Second, Alibaba has committed to spending approximately 380 billion yuan on AI and cloud infrastructure through 2029. So, while its capital expenditures have been high recently, they could grow further in the coming quarters.

In fact, Alibaba just announced a new share placement worth 80 billion yuan, saying that it would invest the money from that stock sale in AI. This suggests that more such secondary stock sales could take place in the future.

That creates important questions for investors: Will the returns from its AI businesses justify the billions Alibaba is spending to build them? And how much more equity dilution will take place along the way?

What does it mean for investors?

Alibaba's latest quarterly results paint a picture that features a fascinating combination of promise and risk for investors.

The green flag is increasingly clear: AI is driving rapid growth in Alibaba Cloud, and the business is beginning to show operating leverage. The red flag is equally clear: Capturing that growth requires enormous investments, which put pressure on cash flow and lead to equity dilution.

That's why the company is at a critical juncture. If Alibaba can turn today's 45% AI-cloud growth into a large, recurring, and profitable business, today's spending could look like a bargain in hindsight. If it can't, investors could discover that building an AI empire is much easier than earning an attractive return from it.

The former premise may make its stock a great buy today, while the latter raises important question marks. Investors should weigh both the upside and the downside before making a decision about buying Alibaba stock.

Lawrence Nga has positions in Alibaba Group. The Motley Fool recommends Alibaba Group. The Motley Fool has a disclosure policy.