Tesla (NASDAQ:TSLA) has been making a ton of headlines recently due to its inclusion in the S&P 500 (NYSEARCA:SPY). We were bullish about the stock reaction and here we at new highs. But another piece of news, the release of the beta version of the Full Self Driving software ("FSD"), is probably much more important. The release of the FSD beta will speed up the development of the software significantly and help bring full autonomy closer to reality.

Elon Musk spoke about hitting Level Five this year. Let's go.

If you’ve been following the release and reviews of FSD Beta, you’ve probably noticed that it’s been relatively quiet. Since the release, no big news on crashes or problems have surfaced. Hopefully it continues and people remain safe! For us, no news is great news. With a big release like this, think about it for a second.

If you follow my work, you know I’ve been pretty uh bullish on Tesla, and you also know that for me, while everyone’s solely focused on deliveries, for me gross margins are the key to the earnings story and the stock price.

We recently raised our price target due to FSD and it's Street leading. I'm not going to give it all away but our 12-month target has four digits to it. But I'm not going to say what it is publicly just yet but it's the Street high.

You know that our targets have hit based on our earnings models X our PE. Simple stuff, but it's been working.

FSD is all about software, so margins will be very additive. That's now starting to get included in my model.

Driving autonomy is a key part of the Tesla bull story, so it’s important to understand the implications and especially the margin and so EPS implications.

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Levels of Driving Automation

Driving autonomy or self driving can refer to a wide range of actions that a vehicle can perform on its own. That’s why the SAE International defines six levels of driving automation. It helps distinguish different types of autonomy. Levels 0-2 are called driver support features, while 3-5 are automated driving features.

• Level 0: Features are limited to providing warnings and momentary assistance, like blind spot warnings or automatic emergency braking.

• Level 1: Control of the vehicle is shared between the driver and system. The features provide steering or brake/acceleration support to the driver, but not both. The driver has to be ready to retake control. It includes features like lane centering, parking assistance, or adaptive cruise control.

• Level 2: The system can provide steering and brake/acceleration support at the same time. However, the driver must still be prepared to intervene if the system fails. It includes features like lane centering and adaptive cruise control at the same time.

• Level 3: The system is fully in control of the car, and the driver can focus on something else. However, the system may request that the driver take control in certain situations. An example would be a traffic jam.

• Level 4: The system is fully in control of the car, and it won’t request that the driver take control of the car at any time. However, it only works in certain conditions (weather, location, etc). If those conditions are not met, the driver would have to take control of the car, or the car will abort the trip and park itself. An example would be local driverless taxis.

• Level 5: The same features as level 4, but it works anywhere and in any condition. The car is fully autonomous and never requires human intervention.

The chart below shows a breakdown of the levels of driving automation.

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Tesla Full Self Driving Beta Release

A couple of months ago, during Tesla’s battery day, Elon Musk teased the release of a beta software for FSD.

"I think we’ll hopefully release a private beta of autopilot, of the full self-driving version of autopilot in, I think, a month or so, and then people will really understand just the magnitude of the change. It’s profound."

About a month later, Tesla launched the FSD beta to a select group of customers in the US, and raised the price of the Full Self Driving option in the US by 25%, from $8K to $10K.

Musk had been saying that the company expects FSD to be widely released soon.

A widespread FSD beta release is key, since it will accelerate the development of the software. FSD is based on a neural network, so the system should improve considerably as more people use it and the system “practices” and faces new challenges.

This is what Musk said about it,

"Having on the order of 1 million cars that are providing feedback and specifically feedback on strange corner case situations that you just can't even come up with in simulation. This is the thing that is really valuable. It's not like the obvious stuff. Obvious stuff you can do in simulation. But weird corner cases, only a reality can give you that. So that's -- but we're able to say, okay, we need to train the system on this corner case situation and look for examples, so we can then train against those examples and improve some very esoteric corner case.

And it's also important to emphasize that this is a generalized neural net-based approach. There is no need for high-definition maps or a cellphone connection. So the car -- the system is designed such that even if you have no connectivity whatsoever and you're in a place that you have never been to before and no Tesla has ever been there, the car should still be able to drive, just like a person. That is the system that we are developing and aiming to release this year."

Q3 Earnings Call

Tesla’s growing footprint is a huge competitive advantage.

The more people that get the FSD beta release and use it, the more the system is optimized. It’s also important to note that this neural net-based approach does not require maps, cell phone connectivity or a previous training in the area. The system is designed so that it will operate just like a person. So in theory, once the software is fully optimized, we could be talking about level 4 or 5 of autonomy. However, we’re still not there yet.

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FSD Beta: Between Levels 2 and 3

Right now, Tesla’s FSD beta release could be classified as either Level 2 or 3. It has the functionality of Level 3, but requires Level 2 type of supervision from the driver.

According to Tesla’s website:

“The system is designed to be able to conduct short and long distance trips with no action required by the person in the driver’s seat.

All you will need to do is get in and tell your car where to go. If you don’t say anything, the car will look at your calendar and take you there as the assumed destination or just home if nothing is on the calendar. Your Tesla will figure out the optimal route, navigate urban streets (even without lane markings), manage complex intersections with traffic lights, stop signs and roundabouts, and handle densely packed freeways with cars moving at high speed. When you arrive at your destination, simply step out at the entrance and your car will enter park seek mode, automatically search for a spot and park itself. A tap on your phone summons it back to you.”

Musk said a few months ago that he expected the basic functionality of level 5 autonomy to be complete in 2020. He was probably referring to the recently released FSD beta, which has the basic functionalities of level 5 autonomy, but is still in testing so it requires constant monitoring from the driver.

Here’s a video of a Tesla with FSD Beta in the real world. The system didn’t have many issues with the tasks it faced, and while it did make some mistakes, the system corrected them and the driver didn't need to intervene. So full autonomy might be closer than some think.

Musk is saying full autonomy will be available in 2021.

“I am extremely confident of achieving full autonomy and releasing it to the Tesla customer base next year. But I think at least some jurisdictions are going to allow full self-driving next year.”

There’s plenty of skeptics of course and FSD timing has been pushed out a few times.

Bears will say it’s unrealistic for Tesla to achieve FSD in the next couple of years, but other companies are close. For example, Walmart and Gatik plan to use fully autonomous trucks to make deliveries in Arkansas starting in 2021. That task, in a “known” environment with optimized routes, is not as hard as Tesla’s goal of level 5 autonomy. The technology used by Gatik is different however it still shows that self driving might be closer than some would believe.

Despite the skeptics Tesla has rewritten the software and released the FSD beta version. This will speed up the development, since it gives the neural network more information to analyze and optimize.

Also, being first is not necessary for Tesla. Unlike most other companies working on FSD, Tesla will already have the advantage of many cars already on the road that can take advantage of the software right away. They won’t have to build a fleet from zero or change their manufacturing lines to sell FSD vehicles.

Musk needs to deliver though. There are plenty who bought into FSD years ago. If it doesn’t happen soon they could ask for their money back. Also there’s investor excitement priced in based on the revenue and earnings potential of FSD. So we need an FSD win here. It sounds like we’re closer based on Musk’s recent comments.

The current version is running for about two months now gathering tons of data and no major issues have been reported. No news is great news for Tesla and FSD and let’s hope it continues. These upcoming months will be key for FSD and Tesla investors.

I think we’re in the midst of a giant Tesla catalyst.

Price and Value of FSD

In April of 2019, Tesla’s FSD had a price of $5K. Since then, the price has doubled. It went up by $1K in May 2019, $1K in November 2019, and $1K in June 2020. Then, with the release of the beta FSD in October 2020, it went up by $2K, to $10.000.

Musk has said multiple times that the value of FSD is worth $100K and he expects the price to keep rising.

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The price is up 100% since April 2019. And there could be more price hikes in the future.

If Musk is right about FSD being worth more than $100K a year, then the price of FSD still has room to go up. The $100k value is probably related to when users have the ability to use their car with FSD to do Uber-like services. Musk for example mentioned the ability to command a “fleet of Uber Teslas.”

Musk also has said FSD will come as a subscription service early in 2021. This should drive trials and improve revenue visibility. You see what’s happening to SaaS stocks moving to subscription, they run.

Margins: The Key Metric for Tesla’s Bull Story

Everyone’s focused on deliveries, but if you follow my work, you know that gross margins are my key metric for Tesla. Gross margins are the key for getting an earnings number, and earnings are what drive stock prices. Margins up, EPS up, stock up.

Bears are ignoring the earnings inflection story. Calls for a bubble and doubt why the stock is up here is based on people not doing the math.

Looking at Tesla’s margins can give you a glimpse at the health of the Tesla bull story.

In the last few quarters gross margins have been trending up, and Musk had a ridiculously bullish comment about margins in the Q3 earnings call.

“And in terms of margins, all of these margins are going to look pretty comically small when you factor in autonomy.”

I’ve been in the business for a long time. I’ve listened to many companies. I’ve found it key to listen to what companies say. This comment was so bullish compared to anything I’ve ever heard from any CEO out there. Margins have been moving up but Musk hinted that there's a potential for a big margin jump from autonomy. That makes a lot of sense.

In Q3 of 2016, Tesla announced that all new Tesla’s would come with all the necessary hardware for FSD. With 500K vehicles in 2020, that would place the number of Tesla’s with autonomy potential at over 1.2 million, with a million more coming in 2021.

Tesla has sold FSD and has unearned revenues waiting to fall through to the EPS line when it gets “turned on.” That moment is coming soon. We’re guessing Q2. So there’s going to be a waterfall of prior period revenues coming in future quarters.

Plus future quarters will start to recognize revenues real time.

There’s a ton of earnings and flow through coming on this event.

Here’s some estimates of the current take rate based on Troy Teslike’s survey. The lower Q3 may have coincided with a price hike.

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We’re starting to model FSD for 2021 which is bumping up our EPS and price target.

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No News Is Great News

The takeaway from the last two months is that no news is great news for Tesla. Since the release of the FSD Beta, most of the reviews that have come out have been great. And while the software is not perfect yet, and it does make some mistakes, no big negative news has come out.

If a FSD Tesla had crashed it would have been all over the news. Naysayers would have made a big deal about it and said that it shows that Tesla would never reach automation. But it didn't happen. It shows the software has been doing well, and with so many miles to train it will keep getting better.

Think about it for a second how big no news is right now.

Musk also has teased the release of the Beta in Canada soon. If FSD had significant problems, Tesla wouldn't be thinking about extending it to another country. The fact that they’re planning to expand the release gives us confidence they’re seeing good results.

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Conclusion

The release of FSD will be a big catalyst for Tesla. It will hype up investors, and drive up margins. Musk has said margins will be way higher once autonomy is factored in. Now, we’re starting to use FSD in our 2021 earnings estimates. If Musk is right, and full autonomy is achieved in 2021, then we still have some meaningful upside potential.