Applied Materials (NASDAQ:AMAT) is the largest semiconductor equipment manufacturer (by revenue) in the world. Therefore, its earnings releases usually give investors a high-level overview of the state of the semiconductor industry.

Unfortunately, this exciting sector is putting up some not-so-exciting numbers right now. The overhang from the U.S.-China trade war is wreaking havoc on memory and semiconductor companies, as end customers continue to be cautious in buying next-generation chips. As Applied Materials makes the machines these chip manufacturers use, the uncertainty is affecting Applied's results as well.

The company's recent conference call with analysts shed some light on Applied's current challenges, but also on how the company plans to grow out of the down cycle. Here's what management had to say about the recent downturn and its prescription for a turnaround.

Check out all our earnings call transcripts.

Applied Materials is undergoing revenue declines. Image source: Applied Materials.

Why revenue and earnings declined

We are currently in a down cycle in semiconductors, especially in the memory market, where Applied earned 56% of its systems revenue last quarter. As a result, Applied's revenue, margins, and earnings have decreased compared with fiscal 2018, which was a banner year for semiconductor equipment sales.

Applied Materials

Q1 Fiscal 2018

Q1 Fiscal 2019

Change (YOY)

Net sales

$4.21 billion

$3.75 billion

(11%)

Non-GAAP adjusted gross margin

47.2%

44.6%

(2.6 percentage points)

Non-GAAP adjusted operating margin

30.1%

24.6%

(5.5 percentage points)

Non-GAAP adjusted net income

$1.17 billion

$0.78 million

(33%)

Non-GAAP adjusted diluted EPS

$1.08

$0.81

(25%)

Data source: Applied Materials Q1 Fiscal 2019 press release. YOY = year over year. EPS = earnings per share.

Not only were last quarter's numbers down, but management projected more declines for the current quarter. Revenue guidance was in a range of $3.33 billion to $3.63 billion, and non-GAAP earnings per share are expected to be between $0.62 and $0.70. Both figures were below analyst estimates of $3.66 billion and $0.77, respectively.

Management now projects 2019 results could fall below those of 2017, whereas on its last earnings call, Applied executives said that 2019 results would be close to even with 2017 figures.

Several headwinds all at once

What's to blame for the worse-than-expected outlook? Management noted that since the November call, "we've seen pre-announcements by end customers -- one company in the smartphones space, another one in the GPU -- and cryptocurrency continues to be weak. So we've taken customer spending down in semi and display." Management had the politeness not to name the end customers in question, but they're most probably Apple and NVIDIA. Both are key chipmakers in the industry, and both came out with terrible pre-announcements for the recent quarter.

To top it off, Applied is also facing a headwind due to the recent industry adoption of extreme ultraviolet lithography. EUV lithography is solely provided by Applied's rival, ASML Holding (NASDAQ:ASML). The adoption of the technology is supposed to displace some of the Applied's etch and deposition machines, which were in high demand to produce leading-edge node chips.

The sun will come out tomorrow?

Despite the ongoing headwinds to its business, Applied's stock has appreciated in the last few months along with the industry, on hopes of a second-half recovery for the year. Management said it expects the recovery to be "slow and gradual," but also that it was not yet ready to "call the bottom," as inventory levels remain high.

On the EUV question, management admitted that it would add a near-term headwind, but that the impact would be relatively minimal. Currently, EUV is mostly being used for logic and foundry chips, not memory, and only on leading-edge nodes. Thus, management claimed that EUV only threatens a portion of the 25% of Applied's business that serves leading-edge foundry customers.

Management also pointed out that many growth industries, such as Internet of Things sensors, will operate on trailing nodes, and won't need EUV lithography. Another example cited by management is a new artificial intelligence chip designed on the 28-nanometer node, which is several generations behind the leading 7-nanometer nodes that need EUV.

In search of a new playbook

When confronted with questions on these tough cyclical and competitive challenges, CEO Gary Dickerson has usually responded by looking even further out, claiming the industry needs "a new playbook," involving, "new architectures, new 3D techniques, novel materials, new ways to shrink transistors, and advanced packaging techniques." In other words, Applied will counter these threats with really cool new stuff that hasn't been invented or released yet.

That's quite a leap of faith Dickerson expects investors to take on Applied's future. While Applied has grown to become the leading semiconductor equipment manufacturer, investors have to believe the current downturn will eventually ease, and that Applied will be able to innovate its way to the next big thing -- something it didn't do with EUV. 

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Billy Duberstein owns shares of Apple and Nvidia and has the following options: short April 2019 $33 puts on Applied Materials. The Motley Fool owns shares of and recommends Apple and Nvidia. His clients may own shares of some of the companies mentioned. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.