Tesla's Hardware 3 Problem is Deadly

Using generous assumptions, Tesla could owe around $42 billion while it only has $37 billion in cash on hand.

• Tesla is being sued on 3 continents for its faulty “Full Self-Driving” (FSD) product.

• Both Chinese and Australian owners of Teslas with HW3 are suing the company because their cars can’t download the latest version of FSD.

• US owners are more deferential to Musk, but will sue for more if the details from Australia and China are ratified in court.

• Figure 3 shows that Tesla could lose as much as $42 billion from reimbursing HW3 customers with HW4.

• The most consequential lawsuit is in Australia, where a group of HW3 owners launched a class action that could show that Tesla not only lied about its “FSD” capabilities, but also sold cars without such capabilities.

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SECTION 1

Cutting Corners

Since peak earnings in 2022, the more that Tesla’s profits dropped, the more relentless the pumps from Musk became over Tesla’s “Full Self-Driving” (FSD) technology and the millions of “robotaxis” it would operate.

This worked so well that, despite Tesla’s 1H 2025 EBIT (ex-credits) of $0.12 billion being 98% below its $5.19 billion peak in 1H 2022, the stock is up over 300% since then.

If one uses Ferrari’s 2026 PER of 32x to value Tesla’s car business ($60 per share) and the average 18x multiple of its rivals for Tesla’s energy storage division ($10 per share), the market appears to be valuing Tesla’s non-existent “robotaxi” business at $1.21 trillion, or $365 per share, which is 84% of Tesla’s current market value.

From that perspective, Musk clearly deserves an Academy Award for being history’s most effective carnival barker, because FSD is still far from being “self-driving” (see Videos 1 and 2 below), and even if it were, Tesla would need many years just to obtain the permits required to run a driverless ride-hailing business (see my deep dive into robotaxis in this report).

Video 1: Tesla’s “Robotaxi” Swerves into Opposite Lane

Source: Twitter.

Video 2: Tesla’s Robotaxi Slams on Brakes Due to Bright Sunlight

Source: Twitter.

The truth is that Musk left a trail of serious missteps in his decade-long effort to get Tesla valued as more than just a carmaker, including product defects and fraud that could wipe out whatever premium Musk created for Tesla’s stock (naturally, after he’s finished pumping it to high heaven ahead of Tesla’s November 6th shareholders meeting).

SECTION 2

Tesla’s Main FSD Legal Liabilities Up To Now

Tesla is facing mounting legal liabilities related to FSD, and these are some of the recent problems that have emerged:

• FSD safety investigations while Tesla tries to get its “robotaxis” approved: In less than 12 months, the US regulator (NHTSA) has launched 4 safety probes into FSD, including crashes that involved fatalities and others that found FSD regularly violating traffic laws. This won’t look good when Tesla tries to obtain the permits needed to roll out its “robotaxi” fleet.

• California state’s big lawsuit: The California Department of Motor Vehicles (DMV) has sued Tesla for consumer fraud due to its marketing of “Autopilot” and “Full Self-Driving” as systems “designed to be able to conduct short and long-distance trips with no action required by the person in the driver’s seat.“ (details in this report). The ruling is set to be out no later than November 26th.

• FSD class-action suit in California: This was approved by the judge after she saw “thousands” of cases where disgruntled owners were suing Tesla over FSD not being “self-driving”. A negative ruling against Tesla in the California DMV lawsuit would bolster this class action, as well as prompt other states with strict consumer protection laws to follow suit.

• Three wrongful death lawsuits lost/settled in the past 2 months: While these all involved Autopilot (the predecessor to FSD until 2020), the evidence that could emerge from the Florida case, in which the jury ruled that Tesla should pay $243 million in damages, could show criminality, according to the attorney who won the case (records are still sealed as Tesla appeals this ruling, but there may have been cover-ups of safety issues).

The “criminality” part of these cases is the real problem. There is ample evidence that Tesla knowingly sold FSD to customers worldwide while (a) knowing some of those cars weren’t equipped with the proper components, and (b) pumping FSD while realizing that its computers were becoming outmoded for the advanced software versions of FSD.

This was all Musk’s doing and could wipe out much of Tesla’s premium if fully exposed. Hence, the insanity of the fact that shareholders are about to vote in favor of Musk’s $1 trillion pay package on November 6th, along with possibly green-lighting Tesla to take a stake in his AI start-up, xAI, which should’ve been launched internally, not outside of Tesla (there’s already a shareholders’ lawsuit in the Delaware court about this, see my report on Tesla bailing out xAI here).

Tesla’s “Hardware 3” Problems Could Explode in Asia

In 2016, Tesla posted a blog on its website that said, “as of today, all Tesla vehicles produced in our factory – including Model 3 – will have the hardware needed for full self-driving capability at a safety level substantially greater than that of a human driver”.

This, along with a marketing pitch on its website saying the same thing (see Figure 1), was quietly deleted in August 2024 (details here), as Tesla realized that its 3rd-generation hardware (Hardware 3, or “HW3”) couldn’t handle future versions of FSD software.

Figure 1: Tesla Deleted This Page on its Website in August 2024

Source: Tesla.

As Tesla’s Full Self-Driving (FSD) software advances, the power needed in its cars’ internal computers increases as well, which is why Tesla began shipping cars with “Hardware 4” (HW4) in Q2 2023 for North American customers (where FSD is the most widely used), and from early 2024 in the rest of the world.

Tesla already knew in 2023 that HW3 didn’t have the power to handle newer versions of FSD, yet kept pumping the product and selling it. Musk only admitted that HW3 might need to be retrofitted on the Q3 2024 earnings call last October:

“HW4 has several times the capability of HW3. It’s easier to get things to work on HW4 and it takes a lot of effort to squeeze that into HW3. There is some chance that HW3 does not achieve the safety level that allows for unsupervised FSD”.

Elon Musk on the Q3 2024 Tesla earnings call.

Roughly 3 months later, on the Q4 2024 earnings call in January 2025, Tesla’s CFO (who sells his Tesla stock options more frequently than any other executive at Tesla) fielded a question about when HW3 might get upgraded and insinuated that there still might be hope for HW3 to work with new versions of FSD.

Musk corrected him by saying this:

“I mean, I think the honest answer is that we’re going to have to upgrade people’s Hardware 3 computer for those that have bought full self-driving, and that is the honest answer and that’s going to be painful and difficult but we’ll get it done. Now I’m kind of glad that not that many people bought the FSD package”.

Elon Musk on the Q4 2024 Tesla earnings call.

Note how Musk admits that FSD sales had been weak, which is cause for relief to him. After all the gamma squeezes he orchestrated with his traders to juice Tesla’s stock price amid deteriorating earnings in 2024, this was hard to take: the pumps were largely baseless.

It’s also highly noteworthy that Musk implies in his January comment on HW3 that only Tesla owners who bought FSD as an option at $10,000 to $15,000 would be reimbursed or retrofitted. This is unrealistic given that HW3 plaintiffs can’t download the latest FSD version.

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Australia and China Could Blow the HW3 Issue Sky High

Tesla just rolled out FSD in China earlier this year and in Australia just last month. One thing they both have in common: Only HW4 owners were allowed to test FSD.

Another thing they both have in common: anyone who bought a Tesla made in Shanghai between late 2021 and late 2023 has a chip missing in their steering rack, which will prevent the car from becoming “fully autonomous,” as Tesla has advertised (details on why here).

Tesla is seeing mounting lawsuits in China from its HW3 owners, who had hoped to use FSD when it was released in China earlier this year, but found out that HW3 trials were stopped, while only HW4 owners could download FSD (see details here).

While FSD was priced between $10,000 and $15,000 in the US, it was similarly expensive in China at US$7,500 (many EV makers in China these days include their more advanced ADAS options as an incentive for higher-end models).

Australian HW3 owners are especially livid: they bought FSD at around US$7,500 years ago but were left out of the long-awaited FSD rollout in Australia last month, which is why there’s a HW3 owners’ class-action lawsuit making the news (here).

The risk for Tesla in both of these lawsuits is as follows:

• During the automotive chip shortage caused by the pandemic between 2020 and 2023, Tesla removed a key microchip needed for any of its cars on HW3 at the time to advance to Level 3 autonomy (Internally, Tesla knew that FSD was only a Level 2 ADAS that still wouldn’t be “self-driving” in the near future).

• CNBC broke the story that Tesla had removed this key chip from their steering racks in cars made in China (great scoop here).

• I wrote about it last year, as the details I saw from a portion of the “Tesla Files” (a huge data dump from Lukasz Krupski, a protected whistleblower in Norway who left Tesla in 2022) showed how hard-up Tesla was for chips in late 2021 (details here).

• Over several days in late November 2021, Tesla made a quick decision based on trying to meet Q1 2022 production targets, that they’d take out chips from China-made cars to both increase production there, but also supply enough chips for US customers, who were big FSD clients.

• This was based on Tesla’s conclusion that FSD wasn’t popular in the APAC region anyway, and they could always “retrofit” the steering racks if needed (little did they know).

Figure 2: FSD Take Rates By Country in November 2021

Source: MH.

While Tesla was toiling over what to do to keep production growing at its most profitable plant in China despite the chip shortage in late November 2021, one email from an engineer noted that the failure rate on a “one-chip” Tesla HW3 car on FSD had a higher failure rate (0.132%) versus those sold locally without the full FSD hardware (0.025%).

They said they’d “escalate” this to Musk, but the following week, all of their cars made in Shanghai only had one chip in their steering racks (not suitable for any self-driving level above Level 3, according to internal emails).

Musk’s Mistakes Will Cost Tesla Dearly

There’s little doubt that Musk made such inane decisions at the time due to his $55 billion bonus award, which still had operational milestones like deliveries and adjusted EBITDA to attain.

If it becomes widely known that Musk sacrificed “safety” for “money” during that time, this becomes an explosive legal liability.

I believe that Musk is always safe in China, so the huge liabilities in Figure 3 for China are probably too large. But North America is probably too small. The lawsuits in China that tend to make big news are being handled by a lawyer who’s believed to be settling out of court with Tesla.

The lawsuit that could blow this entire ordeal up is the one that’s heating up in Australia, by HW3 owners who are miffed not only by having paid a high price of US$7,500 for FSD, but ultimately being left out of the long-awaited FSD release in Australia despite having been “first movers”.

My assumption for the cost of retrofitting HW3 Tesla vehicles with HW4 (which is bigger) is still a generous $2,500 per car, including China, where labor costs are less than half of the US.

Figure 3 below shows the potential costs for Tesla to replace HW3 globally (note that China includes 3x the US$7,500 cost of FSD due to punitive damages asked for by plaintiffs). Key points:

• China likely protects Tesla, so costs won’t be that high.

• North America should be more if punitive damages are included.

• Australia could open this case wide open, which would cause a chain reaction in all of the other global HW3 cases.

Figure 3: Estimated Cost of Replacing HW3

Source: Tesla & MH estimates. Note: China includes 3x the cost of FSD for punitive damages.

What’s more serious is that Australia’s current class-action exposes the fact that Tesla removed FSD chips during the supply-chain disruption that hit delivery targets that Musk needed to achieve in order to make his $55 billion bonus.

Tesla is a house of cards. If one country comes down hard on Musk’s fraud, the weaker ones will follow suit.

NOTE: NOTHING IN THIS NOTE IS INVESTMENT ADVICE.