Tesla's Full Self-Driving Business Is Growing Fast. But There's a Catch for Investors

Tesla's (NASDAQ:TSLA) difficult year continues. On Oct. 21, the company released its third-quarter earnings, and the market wasn't that impressed. Tesla's shares dropped by about 3% post-earnings, adding to the significant market losses it had already incurred this year.

However, Tesla's latest quarterly update wasn't all bad. There were positive signs for the business, including the company's commercial progress with its Full Self-Driving (FSD) software. Let's look deeper into it.

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The FSD software is growing in popularity

Tesla's third-quarter deliveries were very strong. Total deliveries came in at 486,532. Although that declined 2% year over year, it was well ahead of the consensus analyst estimates.

However, the deliveries beat was already baked into the share price before Tesla reported its third-quarter results, since the company announces quarterly deliveries weeks before its update.

Why, then, did Tesla's shares fall after its earnings update? Because the company's actual financial performance was mixed. Vehicle sales declined 3% year over year, and total revenue was roughly flat at $28 billion.

Also, Tesla's non-GAAP net earnings per share dropped by 4% year over year to $0.48. Despite the mixed performance, Tesla made progress in some categories. The company's increasingly popular FSD software was one of them. Active FSD subscriptions grew 67% year over year during the period, reaching 1.74 million.

Tesla charges $99 per month in the U.S. for these subscriptions. The 1.74 million total includes people who purchased the subscription upfront (an option Tesla no longer offers). According to management, the FSD subscription now boasts an annual run rate approaching $1 billion.

That's a tiny percentage of the company's total revenue, but there are several reasons this business is particularly important to Tesla. First, FSD subscription sales likely carry higher margins than electric vehicle (EV) sales.

So, as FSD subscription revenue continues to grow, it could help lift the company's profits, even if it doesn't match EV sales. Second, as Tesla notes, the FSD software is actually helping the company deliver more vehicles.

It seems many customers are increasingly buying Tesla vehicles partly because of the benefits of the FSD software.

In the third quarter, Tesla's FSD attach rate -- the percentage of new buyers who also sign up for the FSD subscription -- reached over 75% in North America, growing nearly 20 percentage points sequentially.

Third, an increasing number of FSD subscriptions should help the company improve its software over the medium term. The more Teslas on the road that run the FSD software, the more data the company has from real-world situations to train and improve the software.

This data flywheel will have important implications for Tesla's entire business. Not only could it help the company sell more EVs, but it may also enable it to improve its robotaxi service.

Is there significant upside ahead?

Even with unimpressive EV sales over the next five years, Tesla's business may improve, provided the company makes substantial progress with its robotaxi business. Tesla launched the Cybercab, a two-seater with no mirrors, steering wheel, or pedals, in September.

The company will be looking to scale its Cybercab fleet over the next few years, and its FSD software will be a key part of its strategy. Assuming a large robotaxi fleet and significant utilization, this business may start contributing meaningfully to the company's revenue growth.

However, there are several risks to consider. First, despite a strong FSD attach rate, the retention rate will be just as important. Tesla does not disclose this metric, but even if the majority of new Tesla buyers opt for the FSD software, it won't be quite as lucrative a revenue stream if a significant number cancel it later. Second, Tesla still has plenty of work to do to scale its robotaxi fleet, and it will need to overcome various regulatory headwinds.

The company was the subject of a federal safety investigation after launching the Cybercab, underscoring that this poses a meaningful risk to the company. Third, and perhaps most importantly, Tesla's valuation seems to already assume significant success across its various projects.

The company is trading at 149.3x forward earnings, which seems incredibly high. Tesla will have to exceed expectations to deliver competitive returns from current levels over the next five years. That's certainly possible, so the upside potential is there. But there is also enough uncertainty to make me a skeptic. That's why I'd avoid Tesla stock right now.

Prosper Junior Bakiny has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Tesla. The Motley Fool has a disclosure policy.