Amazon (NASDAQ:AMZN) recently ramped up production of its own ARM-based Graviton CPUs for its own data centers. Amazon won't sell those chips to other companies, but the move could dent Intel's (NASDAQ:INTC) near-monopoly in the data center CPU market.

Intel controls 96.6% of the world's data center chip market with its Xeon processors according to IDC. It previously controlled 98.6% of the market before AMD (NASDAQ:AMD) forced its way in with its Epyc server chips over the past year.

Two IT professionals walk through a data center.

Image source: Getty Images.

Amazon's development of first-party chips could exacerbate Intel's decline, since AWS (Amazon Web Services) is the top cloud infrastructure platform in the world, and many of its servers are powered by Intel's chips.

Yet the move shouldn't surprise Intel: Amazon acquired ARM chipmaker Annapurna Labs in 2015 to develop first-party CPUs, which include its Graviton CPUs and its Inferentia AI chips for data centers. Other tech giants -- including Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Google, Microsoft (NASDAQ:MSFT), and Facebook -- have also been developing first-party chips for their own data centers.

Why would Amazon produce its own data center chips?

Amazon and its peers in tech realize that it's more cost-effective to produce their own chips rather than place bulk orders from Intel. This strategy also gives Amazon more clout against Intel in price negotiations, and prevents Amazon from being too heavily dependent on a single supplier. That's why Amazon recently announced that it would start installing AMD's Epyc chips alongside its Graviton CPUs in its AWS servers.

Amazon can also design first-party custom chips for specific cloud services, which could provide more flexibility than Intel or AMD's chips. Intel designed custom chips for AWS before, but moving the process in house could save time and money. Amazon believes its new chips will require less power than Intel and AMD's solutions.

Tightening its control over its cloud software and hardware could also help AWS compete more effectively against Microsoft's Azure and Google's Cloud Platform. Amazon already plans to offer a new cloud service powered by its own in-house chips to enterprise customers, and it could cost 45% less than other options according to The New York Times.

Servers in a data center.

Image source: Getty Images.

AWS is Amazon's core profit driver. During the first nine months of 2018, its operating income surged 72% annually and accounted for 59% of its operating profits. The growth of that higher-margin business offsets the lower margins of its North American and International marketplace units. The development of in-house chips could initially weigh down AWS' profits, but it could boost its margins over the long term.

Should Intel be worried?

Intel repeatedly admitted that competition from AMD and first-party chips from big cloud providers would dent its market share in data centers. In a meeting with Nomura Instinet analyst Romit Shah earlier this year, then-CEO Brian Krzanich stated that Intel was merely trying to prevent AMD from gaining a "15% to 20%" share of the data center market rather than shut them out. Despite those headwinds, Intel's Data Center Group (DCG) business has remained strong over the past year.

 

Q4 2017

Q1 2018

Q2 2018

Q3 2018

DCG Revenue

$5.6 billion

$5.2 billion

$5.5 billion

$6.1 billion

YOY growth

20%

24%

27%

26%

Source: Intel quarterly reports.

Intel attributes that growth to strong CPU shipments for servers, storage, and network devices as it secured more enterprise customers. In other words, Intel's overall market share is declining, but its total addressable market (TAM) is still rapidly expanding since most of those customers lack the resources to produce in-house chips like Amazon.

Moreover, Amazon, Microsoft, and Google won't simply replace all of Intel's "best in breed" Xeon CPUs with their own chips anytime soon. It would be too expensive, and it could adversely impact the performance of their servers -- which would be considered a disastrous misstep in the cutthroat cloud service market. That's why most data centers in China are still powered by Intel's Xeons, despite the Chinese government's attempts to reduce its overall dependence on American technology.

The key takeaways

Amazon and other US tech giants are producing more in-house chips to reduce their dependence on Intel, but they won't completely stop using its flagship Xeons anytime soon. Meanwhile, Intel will cede market share to AMD and these tech companies, but its data center business should remain strong as it expands its overall market.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, and Facebook. The Motley Fool owns shares of Microsoft. The Motley Fool has a disclosure policy.