Is AI Actually Bad for Business? A Look at Duolingo's Margins

Shares of Duolingo soared this week after the popular education app raised its annual sales forecast, signaling strong demand for its subscription services. But buried beneath the bullish revenue outlook is a more complicated and cautionary tale about the real-world economics of artificial intelligence. Even as sales grew, the company's gross margins shrank, a decline it attributed to its aggressive, AI-driven expansion into new subjects like music and math.

Duolingo's situation is a powerful case study for a paradox now confronting the entire software industry. For years, investors have prized software for its high margins and capital-light business models. But the race to infuse every product with cutting-edge AI is proving to be an incredibly expensive endeavor, one that threatens to erode the very profitability that made these companies so attractive in the first place.

Why is AI squeezing Duolingo's profits?

The numbers tell a clear story. Duolingo's gross margins fell to 72.4% in the second quarter, down from 73.4% a year earlier. While the company noted that AI costs came in lower than anticipated, the downward trend highlights the inherent expense of the technology. Building, training, and deploying generative AI models at scale requires massive investment in three key areas:

• Computing Power: Running the complex calculations for AI requires enormous amounts of processing power, leading to soaring cloud computing and data center costs.
• Talent: The competition for elite AI researchers has become a full-blown arms race, with companies like Meta reportedly offering nine-figure compensation packages to lure top talent.
• Acquisitions: To speed up its push into new verticals, Duolingo just made its largest-ever acquisition, buying the 23-person music-gaming startup NextBeat.

This shift represents a fundamental change to the software business model. The industry is moving from a world where the primary cost was human software engineers to a new era where the primary costs are capital-intensive infrastructure and a small, hyper-expensive class of AI specialists.

But isn't AI supposed to make companies more efficient?

Yes, and this is the core of the paradox. AI is also a powerful tool for cost-cutting. Companies across the economy are using AI agents to automate tasks previously performed by humans. Duolingo itself is a prime example of this; last year, the company made headlines for using AI to replace the work of some human translators.

However, the savings from automating some roles are, for now, being offset by the massive new spending required to build the AI itself. For a company like Duolingo, which is using AI not just to cut costs but to fundamentally expand its product line, the net effect is a short-term hit to profitability. The bet is that this investment will pay off in the long run by attracting new users and creating a larger, more defensible business.

Why is Duolingo taking this risk?

The company finds itself at a strategic crossroads. Its growth in daily active users has slowed to its weakest rate since 2022. This suggests that its core market of casual language learners may be approaching saturation. To continue growing at the pace Wall Street expects, Duolingo has to find a "second act."

Its chosen path is to become a "super app" for learning, expanding into math, music, and even chess. AI is the key to making this expansion possible quickly and at scale. "We want to try to catch up in music and in chess and in math and have them be a bigger part of our business, faster,” said Chief Business Officer Bob Meese. The company is effectively trading some of its high margins today for the promise of a much larger total addressable market tomorrow.

What are the biggest hurdles ahead?

The primary challenge is proving that the super app strategy can work without permanently damaging the company's financial structure. Investors have rewarded software companies with high valuations precisely because of their high margins. If the "AI tax" becomes a permanent feature of the business, it could lead to a fundamental repricing of the entire sector.

Furthermore, expanding into new categories pits Duolingo against a host of new, specialized competitors in music, math, and other educational fields. The company is betting that its brand, massive user base, and AI-powered development speed will allow it to win in these new markets. For now, Wall Street is focused on the rising revenue forecast. But the quiet decline in margins is a sign that the AI revolution, for all its promise, does not come cheap.

The Reference Shelf

• Duolingo Lifts Sales Outlook as It Widens Non-Language Offerings (Bloomberg)
• The great AI jobs disruption is under way (Financial Times)
• Enterprise AI adoption stalls as inferencing costs confound cloud customers (The Register)