The ongoing fourth industrial revolution has undoubtedly had a significant impact on virtually all aspects of society and business, and in this disruptive digital landscape. This study investigates the critical internal capabilities that enable small and medium enterprises to effectively adopt AI-driven innovations in the South African context. By examining key factors such as AI readiness, organizational learning capacity, strategic flexibility, and data management capabilities, the research provides a comprehensive analysis of their impact on AI-powered innovation performance. Using structural equation modelling to analyse data from SME owners and managers, the findings reveal significant positive correlations between these internal capabilities and innovation success. The results highlight the importance of investing in technological infrastructure, fostering a learning-oriented culture, and enhancing data management systems to ensure sustained competitiveness in the rapidly evolving AI landscape. These insights are crucial for SMEs aiming to leverage AI technologies for business growth and for policymakers seeking to support technology-driven sector development in emerging markets.