Autopilot Does Not Need to Achieve Full Self Driving to Become a Key Competitive Advantage

There has been a somewhat separate line of debate between bulls and bears around Tesla’s autopilot business, which Elon Musk has been pushing as a key component of Tesla’s longer-term growth plans. The debate revolves around the value of the business and whether it will achieve fully autonomous capabilities. Elon Musk has recently stated on Lex Fridman’s AI podcast that Tesla was ahead of the competition and will be achieving feature-complete self-driving capabilities soon.

On one hand, numerous bears, and many experts in the AI community, have argued that Tesla is well-behind in self-driving capabilities. Google’s Waymo is widely perceived as the leader in the space with the fewest disengagements per mile, some progress towards commercialization (with Waymo One), an army of machine learning experts, and a first-mover advantage. Meanwhile, Elon has made numerous promises (including a cross-country drive that was supposed to happen by the end of 2017) but has yet to live up to his statements. In an era of loud, visionary startup leaders that make bold, borderline-fraudulent statements (see Theranos and Fyre Festival), many are fairly skeptical.

In my view, this is an interesting line of debate that is rife for additional investigation. Many of the street analysts are largely taking the conventional wisdom that Waymo is ahead based on superficial analyses, but are not diving deeper. There have been numerous people more deeply involved with disengagement data that have argued that the data is too easily manipulated to be of much use as a measuring stick for progress. Additionally, several passengers in Waymo One have noted that they have seen drivers taking control of the vehicle on several occasions.

I am admittedly not well-equipped to opine on who will achieve full autonomy first, or how long it will take. With that said, I view the autopilot feature from an investing lens in two ways.

First, Tesla does not need to achieve full autonomy to reap financial benefits. Tesla’s current self-driving features remove a significant mental burden for long commutes. While drivers still must monitor the vehicle and be ready to take over at all times, the mental drag is lower than if one were driving the vehicle fully. This is a strong feature that could change the way we see driving and what we expect out of our cars. And unlike full autonomy, this is available today and a much less daunting task to improve upon. As this feature becomes more widespread, it could become “table stakes” - in other words, it could be expected in a vehicle for it to even be viable as a potential purchase.

To be fair, other vehicles today offer certain degrees of autonomy. For example, many systems can manage braking, steering, and acceleration. However, few vehicles offer a more holistic experience like Tesla. Additionally, without over-the-air (OTA) capabilities, manufacturers cannot improve on its autonomy features over time. This latter point is key given that an autonomous/semi-autonomous vehicles are expected to get better with time. For now, I would argue that Tesla has a lead in commercialization (for level 2+) and a competitive advantage over other vehicles.

As a result, Tesla does not need to achieve full autonomy in order to recognize the value of its autopilot program. With its current autopilot capabilities today, and projecting out modest, ongoing improvements, Tesla has a key differentiating feature in its vehicles that 1) benefits sales and differentiates Tesla vehicles further from the competition, and 2) benefits gross margin significantly.

Second, while I am not yet in the camp that Tesla will achieve full autonomy soon, I do view the possibility as a call option on the stock. Tesla’s approach is meaningfully different from the other auto OEMs and software companies, in part because they hold a key asset: data. Tesla decided to forego LIDAR, and equipped all of its vehicles with OTA capabilities. These decisions gave Tesla a fleet of vehicles (affordable to the consumer) that are capable of collecting data that could then be used to further train its neural net. It is not yet clear to me if having more data will ensure that Tesla will achieve full autonomy first. However, it seems like a real possibility given that more real-life data is often a key factor in improving performance for several different machine-learning approaches. Because Waymo is not able to collect enough data on real-life edge case scenarios, they are forced to hand code the proper response. Meanwhile, Tesla is potentially able to use its extensive data (which presumably holds many more instances of certain edge case scenarios) to train its neural net for the optimal response.

It’s important to appreciate just how difficult it is to solve full autonomy. Much of the game-changing features, like having a car that can earn money for you in the Tesla Network, comes in having no driver at the wheel of a car. But for this to be achievable, the vehicle needs to be able to handle all sorts of long-tail events in a safe way that also balances the passenger’s need to get to their destination in a timely manner. Think about it this way: over your last two weeks of driving, how many times did you come across a long-tail scenario that required you to break the rules of driving, and to use a more generalized knowledge of the world? And how many times might one come across these scenarios while driving 250,000 - 500,000 miles (the typical distance a human driver will drive before getting into an accident)? To achieve full self-driving, and for it to not be disruptive on the roads, an autonomous vehicle will need to know how to handle all of these situations quickly, and safely.

Due to this difficulty, I’m not yet ready to start baking in autonomous driving products (like the Tesla Network) into the valuation of Tesla as a whole - hence the call option view. At the same time, I also believe that semi-autonomous driving can still prove to be a meaningful differentiator for Tesla vehicles, and a gross margin benefit. And the stock could meaningfully appreciate if Tesla makes further progress in getting towards full autonomy.

As a result, autopilot developments should be monitored closely, and investors can start with the Autonomy Investor Day that is expected to occur on 4/22 (which is perhaps the day this article is published). Going forward, if Musk’s statements are true, Tesla’s autopilot improvements should become more rapid now that Hardware 3.0 is rolling out to more vehicles.





The Gross Margin Puts and Takes

Tesla must also show that there is sufficient demand at an acceptable level of gross margin. This has become an even larger point after Tesla’s announcement of the $35,000 Model 3, which Tesla has hinted at in the past as not yet being profitable. It would not be beneficial to Tesla if they are only able to show that sufficient demand exists at a price point where gross margins are negative.

There are several puts and takes here, but there are enough data points to suggest that Tesla can stay profitable:

Numerous sellside analysts have come away from Fremont factory tours confident that the company can continue to grow production to 7,000 per week with minimal incremental capital expenditures. Several have noted that numerous parts of the factory were built with scale in mind (Wedbush, Canaccord, Macquarie as examples). Increasing production volumes should drive gross margin expansion.

Management noted that maintaining gross margin above 20% should be achievable with ASPs in the mid to high $40K range. This appears doable given that Tesla’s peers (BMW and Mercedes) all have similar ASPs.

One question that could be key in the near-term is how different gross margins for high-end Model 3s and entry-level S/X's are. Based on what we know, they may not be too dissimilar, based on the following: 1) High end model 3's have gross margins north of 20%, 2) Model S/X, inclusive of all trims, have gross margin in the mid to high 20s (based on data prior to when the model 3 went on sale, as well as management commentary), 3) Tesla was only shipping high trim Model 3 vehicles internationally in 1Q19 (the 20%+ gross margin models), and 4) Tesla discontinued the entry-level S/X at the beginning of the quarter (which are likely to be below the overall S/X gross margin of mid-to-high 20s). If gross margins for the high-end model 3 are similar to the entry-level S/X, then we could potentially see a modest surprise in 1Q gross profit, as it is perhaps not as horrible as some might fear. Consensus currently calls for 19.6% auto gross margins, excluding ZEV credits.

The US had about 100K units of high-trim Model 3 demand (in 3Q and 4Q). With a larger appetite for luxury sedans in the EU, and an enormous Chinese market that has yet to be fully tapped into, it seems feasible that global demand for high trims could be at a similar level. With an estimated 30K delivered already in 1Q (50K total Model 3s delivered minus the 20K Model 3s reported to be delivered in the US), this would imply that we could see another quarter or two of high-trim demand internationally. The mix benefit could offset the mix headwind from the $35K Model 3 deliveries in the next several quarters (which has now been moved off-menu).

As mentioned previously, Autopilot and Full Self Driving provides a significant gross margin boost, and could alter the margin trajectory as the service improves over time. Tesla’s decision to make autopilot a standard feature in all vehicles should provide a meaningful benefit. As an illustrative example, a Standard Range Plus with a 5% gross margin would generate a 16% gross margin with the Full Self-Driving package.

On the negative side, gross margins are likely to dilute over time as the Model 3 mix shifts towards lower ASPs over time. Additionally, we could see further cannibalization if Tesla does not manage its good-better-best offerings carefully with the Model 3/Y and the S/X. And of course, if demand falls short of production, we could see further margin headwinds and potentially other price announcements to incentivize customers to purchase.





Tesla Needs to Demonstrate Profitable and Sustainable Demand to Fund Its Next Leg of Growth

Tesla’s growth plan is to continue to expand into other categories (like the $40-60K SUV segment with the Model Y) and continue to capture similar market share levels as their current products. For the stock to work, Tesla must continue to fund the next expansion and demonstrate continued demand in each segment.

Naturally, Tesla’s largest step-ups in revenue have also come from the launch of new models into new segments. Looking at Tesla’s history, the largest revenue gains have come once the new models began volume production. And the largest stock movements have similarly come sometime between the announcement of the next model and the volume production ramp.