What Is Apple Intelligence?

Summary:

• Apple finally announced their AI initiatives at the Company’s Worldwide Developer’s Conference in mid-June.
• The preceding narrative on the ‘Street was Apple is woefully behind in “AI.”
• Narratives can change in a heartbeat on Wall Street, and my, have they changed fast as Apple has brilliantly relabeled “artificial intelligence” as “Apple Intelligence.”
• Given the interplay between semiconductor design and software in AI, we’d like to share our thoughts on Apple’s silicon prowess.

The following segment was excerpted from this fund letter.

Apple (NASDAQ:AAPL) finally announced their AI initiatives at the Company’s Worldwide Developer’s Conference (‘WWDC’) in mid-June. The preceding narrative on the ‘Street was Apple is woefully behind in “AI.” Never mind the fact the Company has been deep into AI for years. For example, two features built into the Apple Watch (fall detection and crash detection) are examples of AI “machine learning.”

Well.

Narratives can change in a heartbeat on Wall Street, and my, have they changed fast as Apple has brilliantly relabeled “artificial intelligence” as “Apple Intelligence.” No slouches these Cupertino folks.

We have owned Apple continuously since late 2005. While Apple is a quite a different company from what it was 18 years ago, in a key aspect, Apple is very much the same company. In preparing to write about Apple for this Letter, we traveled down memory lane to reread our first Letter on Apple way back in early 2006. And what a trip it was.

It would be 12 short months before Steve Jobs would introduce the world-changing, revolutionary iPhone, but in early 2006 the Company’s iPod “ecosystem” and overall company “halo-effect” were in full bloom. So much so, that we wrote back then, “The bottom line: iPod has become to mp3 players what Kleenex has become to tissue paper.”

Torrent iPod growth wasn’t the only story emanating from Cupertino then. Mac growth was up +38% in fiscal 2005. In the Company’s most recent quarter then, Mac shipments grew +48% the second-best quarter of growth on record at that time. Mac was taking swaths of market share. Such market share take would continue in the intervening years as the Company was rapidly transitioning its entire Mac lineup to the prolific Intel (INTC) microprocessor.

The key competitive advantage of Apple circa-2005 – ecosystem, halo-effect – remains considerably stronger today. Once a new customer enters the Apple ecosystem they stick around for years, buying an ever-growing list of new hardware products and software services.

We wrote the following then:

“Few of us have time, let alone, the desire to become product specific, digital experts. We want, no, check that – demand that our digital devices seamlessly connect to one another with absolute minimal effort and angst on our part as users.

“This is where Apple Computer excels.

“Apple customers, whether they be iPod, iBook, iMac, Mac mini, PowerMac, PowerBook or Xserve users know that all of Apple’s products connect and communicate with the ‘ease of use and adoption’ (There is that phraseology again) unlike any other family of products, much less any other combination of independent digital products.”

“The hub of the Company’s product integration is the Apple Store. We dare say that the uniqueness of Apple stores has become a ‘Digital Ellis Island’ for people just entering the digital world. The Company has just 130 stores worldwide, yet they are a marvel of consumer experience. Here is one key Apple store stat to keep in mind – and one that we will monitor closely as long as we are Apple investors – the Company reports that 45% of the customers buying a Mac in their stores are new to Mac. This stat speaks volumes to us. For Apple Computer to sustain growth, take market share and leverage incremental sales to higher levels of profitability, the Company must capture new users. It appears to us that they are doing that in droves!”

Fast forward to the past 12 months. The Company reports the following:

• Third Quarter 2023. Nearly 50% of Mac buyers were new to the Mac. Over 50% of iPad buyers were new to iPad.
• Fourth Quarter 2023. Two of three college students choose Mac. iPhone set new record for switchers. Mac installed base at all-time high. Over 50% of Mac buyers were new to Mac. Over 50% of iPad buyers were new to iPad. Nearly 66% of Apple Watch buyers were new to Watch.
• First Quarter 2024. 100th retail store opened in Asia/Pacific. Almost 50% of Mac buyers were new to the Mac. There was an all-time record of iPhone upgraders. Installed base of active devices surpassed 2.2 billion – an all-time high, across all products and geographic segments.
• Second Quarter 2024. All-time services record reached. Installed base of active devices is at an all-time high. Installed base of active iPhone is at an all-time high. Installed base of iPad is at an all-time high. Almost 66% of Apple Watch were new to Watch. Paid subscription across Services was +1 billion. Both paid and transacting accounts reached an all-time high.

So, what is Apple Intelligence? Apple Intelligence is Apple’s use of artificial intelligence (AI), specifically “generative AI,” in which the Company will embed personalized, user-approved access of their respective data within email, messages and photos, enhanced then with generative AI content, including text, imagery, audio and synthetic data, including the integration of OpenAI’s ChatGPT into the Company’s operating systems – most notably Siri at first – powered by at least the iPhone Pro 15. The soon-to-be released iOS 18 and macOS Sequoia will leverage Apple AI silicon on-device processing across software products including Mail, Notes, Pages, Safari, Voice Memos and Photos across on-device iPhone, iPad and Mac.

Siri, employing Apple device generative AI small language models, will offer the most comprehensive Apple Intelligence at first, with a deeper dive in time into Apple apps. For example, the Company states:

“Siri will be able to deliver intelligence that’s tailored to the user and their on-device information. For example, a user can say, ‘Play that podcast that Jamie recommended,’ and Siri will locate and play the episode, without the user having to remember whether it was mentioned in a text or an email. Or they could ask, ‘When is Mom’s flight landing?’ and Siri will find the flight details and cross-reference them with real-time flight tracking to give an arrival time.”

The rollout for Apple Intelligence will be modest in scale, scope and pace and will be presented first in English. Hardware requirements for AI will require the latest and greatest Apple Silicon, plus a heavier dosage of on-device memory. The iPhone upgrade cycle will certainly get an AI upgrade tailwind, but that too will be modest after the usual earlier adopter’s upgrade and first-time buyers to the iPhone. Indeed, Bloomberg reports that Apple plans to ship at least 90 million iPhone 16s in the latter half of this year, +10% above prior launches, as the Company counts on artificial intelligence (Apple Intelligence) services to drive demand.

We expect other collaborations with AI large language modeling tools from Alphabet (GOOG,GOOGL) and Anthropic. Please note, Apple is in the enviable position for consumers to access AI as any number of AI providers would be first in line to collaborate with Apple and its gold mine of soon-to-be millions of active AI purposed devices – yet another lock in feature of Apple’s ecosystem. Note too that just as Apple partners with Alphabet with Google Search, Apple, at least in its AI early innings, may never need to expend countless billions building its own AI large language models, so it will choose best-in-class partners and others in time in AL. At the end of the day, we expect Apple Intelligence to be an evolutionary rather than a revolutionary feature in terms of enhancing the user experience, allowing Apple users their ability to “step their toes in the water” of the new, uncertain world of Artificial Intelligence.

Future iterations of Apple Intelligence that may surprise could well be centered not on off-device ChatBots, which are large language models, but rather silicon developments within Apple’s “edge” devices (e.g., iPhone, Mac, iPad), in addition to significant silicon developments within Apple Cloud, particularly in the realm of Apple’s obsession with customer security and privacy.

A few years ago, in our fourth quarter 2021 Letter we commented on Apple’s often overlooked semiconductor design superiority, about which we expect to hear much more over the next few years. Given the interplay between semiconductor design and software in AI, we’d like to again share our thoughts on Apple’s silicon prowess:

“Apple continues to develop new products and services that capture dominant profit share in some of the largest and most competitive industries around the globe¹. Having owned Apple continuously for the past 16 years, we find it surprisingly difficult to know what new products the Company will unveil over a multi-decade timeframe. For example, in 2006, we did not know Apple would sell MacBooks with Apple-developed CPUs starting in the year 2020. In 2006, Apple had just made a huge pivot by launching its first Intel-based computers, moving away from IBM PowerPC.² But we did know that Apple’s vertically integrated (software and hardware) product development strategy was unique and extremely capable of creating products and experiences that customers thought worthwhile enough to spend growing amounts of time and money on. Today, that development strategy culture is still intact and as entrenched as ever thanks to Apple’s methodical long-term investments in key areas such as semiconductors and integrated circuits (‘IC’), which have been complemented by continuous software innovation.

“In just a few years after Apple’s switch to Intel for its PCs, Apple made a couple of strategic acquisitions that launched its internal semiconductor development platform. These acquisitions, including PA Semi and Intrinsity, saw the Company add several hundred silicon engineers in the process, initially with the stated goal of expanding Apple’s parallel processing capabilities for its line of Mac computers.³ However, Apple’s first internally designed system on a chip (‘SoC’), the A-4 (launched in 2010), was not a multicore chip, nor was it designed for a PC. Yet by 2011 it was rumored that Apple had “1,000 engineers working on chips.”⁴

“With the introduction of the iPhone and the creation of the Open Handset Alliance in 2007, off-the-shelf solutions for the touchscreen smartphone industry exploded, setting up supplier-customer dynamics reminiscent of the “Wintel” era of the 1990’s. Samsung, Qualcomm, Broadcom, and NVIDIA (to name a few) often provided off-the-shelf inputs for original equipment manufacturers (‘OEM’) like Nokia, Samsung, ZTE, Sony, and Apple. By definition, these inputs were not custom made; therefore, those parts alone would not provide any sort of differentiation. So, the real benefit of recruiting semiconductor design talent was that Apple could create custom inputs to make products that would significantly stand out from the competition.

“Apple has developed well over a dozen custom processors and other integrated circuits since it launched its first “A-series” processors. The A-series processor family seems to be an annual iteration of Apple’s mobile CPUs, often enabling new iOS-specific functions that sometimes takes competitors years to mimic. For example, in 2017 Apple’s A11 Bionic processor featured a “neural processing unit” that provided the iPhone X with enough processing power specifically dedicated to operating the device’s FaceID 3D mathematical algorithms so users could securely unlock their phones and also make digital payment authorizations. It took years for competitors to copy this feature using similar biometric scanning, but even those have been sparingly embraced by users, meanwhile Apple’s FaceID helps authorize over 600 million payments per year.⁵ Payments alone are probably not a huge reason to go out and buy an iPhone or iPad, but after more than a dozen years of chip iterations we would argue that regular device feature innovations along with quality improvements have yielded a consistent and differentiated value proposition that regularly convinces consumers to stay and grow in the Company’s lucrative ecosystem.

“To capture the vast majority of the profit share in mobile, Apple has had to do more than generate revenue by focusing on user experience. The Company has also had to maintain a disciplined value chain to keep expenses under control. One obvious but immensely important aspect of their strategy has been a focused product set. This concentrated purchasing power likely affords raw chip procurement economics that are not far from off-the-shelf solutions.⁶ In addition, Apple has been able to secure leading-edge fabrication technology at its fabrication partners at huge scale. This rare capacity alone provides a multiyear head start on many processing competitors. So, Apple can reap the benefits of custom chips without paying exorbitant prices, which creates value for most everyone involved.

“We expect Apple’s strategy of differentiation through silicon will continue for years to come. According to Apple’s website, Apple currently has as many job openings for silicon-related development as they do for software applications and frameworks. More recently, Apple has started to displace Intel CPUs from its PC lineup and replaced it with Apple’s M-Series silicon. Apple also plans to replace Qualcomm modem silicon by including an internally developed modem on upcoming A-Series processors.⁷ Of course, Apple does not participate in the server CPU market or cater to hyperscale customers, despite iCloud, the App Store, and all of its other cloud-based services. However, we would not be surprised if one day Apple tried to bend the curve in the cloud. None of these moves are mean feats given Intel and Qualcomm have been competing in processor design and production for generations.

“Apple has effectively created a semiconductor business that rivals and even surpasses some of the most established semiconductor-focused businesses in the industry. Apple continues to differentiate through vertical integration, which has been a hallmark of Apple’s long-term strategy to grow and capture superior profitability. It is difficult to predict what new products will be unveiled; however, we think this strategy should continue to serve shareholders quite well.”

And from a more recent Letter is the following:

“Apple continues to develop new products and services that capture dominant profit share in some of the largest and most competitive industries around the globe. Having owned Apple continuously for the past 16 years, we find Apple’s vertically integrated product development strategy has been consistently ahead of the curve, including their capabilities in machine learning and AI.

“Apple has developed well over a dozen custom processors and other integrated circuits since they launched their first “A-series” processors. The A-series processor family enables Apple-specific functions that sometimes takes competitors years to mimic. For example, in 2017 Apple’s AI muscles began to flex with their A11 Bionic processor which featured a “neural processing unit” that provided the iPhone X with enough processing power specifically dedicated to operating the device’s FaceID 3D mathematical algorithms so users could securely unlock their phones and also make digital payment authorizations. It took years for competitors to copy this feature using similar biometric scanning, but even those have been sparingly embraced by users.

“Meanwhile Apple’s FaceID helps authorize over 600 million payments per year. FaceID is now standard for most Apple mobile devices – which we think ships over 200 million units per year – thanks to the Company’s investment in and development of its neural processing units.”