Why Apple’s AI Success Hinges on the iPhone

The phased launch of Apple’s first generative AI service complicates the picture further; the first features of Apple Intelligence launched Monday—more than a month after the iPhone 16 started shipping. Apple plans to continue adding AI features to its iOS software throughout next year, which may drag out iPhone 16 adoption more than usual. “Gradual AI feature rollout could be hindering a more pronounced upgrade cycle,” Krish Sankar of TD Cowen wrote in a note to clients on Friday. 

The concerns have weighed on Apple’s stock. The shares are up less than 5% since the iPhone 16’s launch event in early September, which lags behind other megacap techs and the S&P 500 in that time. 

Apple has experienced weak iPhone cycles before, given the maturity of the business and the longer periods that consumers are going between upgrades. But the company’s hardware-centric business model means its devices are the only way to get its generative AI services to its customers, and by far the most important of those are its phones. Those customers have to be willing to pay up for the privilege; only the iPhone 15 and 16 models are capable of hosting Apple Intelligence, and those models with their various memory configurations average a price tag of a little over $1,000. 

By contrast, Apple’s big tech rivals can distribute AI capabilities across a wide base of users without such an expensive surcharge. Facebook parent Meta Platforms rolled out its Meta AI assistant free of charge to more than a dozen countries last month—and has a base of nearly 3.3 billion daily active users globally to tap. 

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As AI capabilities move from cloud services to “edge” devices such as smartphones and PCs, Apple has a natural advantage as the world’s predominant maker of such products. But there is some question as to whether the current crop of AI smartphones can really deliver powerful experiences. “Unlike AI servers, smartphones lack high-speed memory and advanced packaging tech that allow fast data transfer between AP and memory, thus limiting their AI capabilities,” Jefferies analyst Edison Lee wrote in a note to clients earlier this month. He downgraded the firm’s rating on Apple’s shares to hold. “To expect an accelerated smartphone-replacement cycle now due to AI is premature, in our view.” 

And even with the recent weakness, Apple’s stock is up nearly 36% over the past 12 months, beating out Microsoft and Google-parent Alphabet, which have been the most aggressive among big techs for their adoption of generative AI into their offerings. Apple is also trading a little over 31 times projected earnings for the next four quarters—a 20% premium to the stock’s five-year average, according to FactSet data. 

Hence, the shares still face some risk if the iPhone 16 falls short. The coming earnings report will include a little over a week of sales for the new models—typical for the period. Expectations are modest but not exactly low. Analysts estimate that iPhone revenue grew 3% year over year in the September quarter, identical to what the company showed for the same period last year. 

Much will ride on what Apple says about the December-ending quarter, especially since the company no longer gives specific financial forecasts. Analysts expect iPhone revenue growth to pick up, rising 5% year over year to $73.2 billion, according to consensus estimates from Visible Alpha. 

But many are also watching for signs that Apple may cut its production plans. “To be clear, we have not heard of any iPhone build cuts in our checks, but after a month of tracking iPhone 16 demand indicators, we’d characterize iPhone demand as mixed,” wrote Erik Woodring of Morgan Stanley in a report Tuesday. He remains positive on Apple, calling the company “the best-positioned Edge AI winner over the next 12+ months.”

Apple might need that long or longer to prove the thesis right.

Write to Dan Gallagher at dan.gallagher@wsj.com