D.A. Davidson analysts downgraded Microsoft (NASDAQ:MSFT) on Monday from a Buy to a Neutral rating, while maintaining a $475 price target.
The firm cited intensifying competition in AI as the reason for the revision, noting that competitors have largely caught up with Microsoft's AI capabilities, “which reduces the justification for the current premium valuation.”
The tech giant’s shares have surged 92% since January 2023, outperforming the S&P 500's 49% gain during the same period.
Microsoft had previously taken a significant lead in both cloud business and code generation by being the first to embrace and commercialize generative AI. This was largely due to an early investment in OpenAI and rapid deployment of capabilities within its Azure and GitHub platforms.
However, D.A. Davidson now believes that Microsoft's lead has diminished as Amazon (NASDAQ:AMZN) Web Services (AWS) and Google (NASDAQ:GOOGL) Cloud Platform (GCP) have shown comparable growth rates and are closing the gap in cloud business additions.
“Our new proprietary hyperscaler semiconductor analysis indicates AWS and GCP are far ahead in terms of deploying their own silicon into their data centers, which gives them a significant advantage over Azure going forward,” analysts said.
Microsoft's Maia chips are still years behind those of Amazon (AMZN) and Google (GOOGL), with current use limited to running Azure OpenAI Services workloads. This, analysts note, puts Microsoft in a difficult position in the escalating data center arms race.
Microsoft's reliance on Nvidia (NASDAQ:NVDA) for data center operations is also seen as a potential weakness, as it could lead to a shift of wealth from MSFT shareholders to NVDA’s. The company is now experiencing operating margin declines due to increased data center capital expenditures, which are growing from 12% to 21% of revenue.
“This is a higher rate of increase compared to Amazon and Google, a result of Microsoft’s greater reliance on NVIDIA,” analysts point out.
“Every year Microsoft over-invests at these rates, it will diminish margins by at least 1pp in a cumulative manner. Microsoft would need to lay off ~10,000 employees for every year of over-investment in order to offset the margin drag.”
Lastly, analysts voiced concerns about the quality of Azure's revenue growth, which may be inflated by self-funded revenue from OpenAI.
Microsoft's investment in OpenAI, which exclusively operates on Azure, could be considered lower quality revenue that drives much of Azure's recent acceleration. Moreover, competition in code generation tools has increased, with Amazon and Gitlab catching up to GitHub Copilot's capabilities, and Cursor emerging as a new industry standard.