Contractors face fight-or-flight decisions.

• Author: Erwin, Sandra I.
• Position: Defense Watch

* The defense industry has only just begun to feel the sequester bite. Most of the top players--as evidenced by stock prices and executive compensation over the past two years--continue to prosper even in a down market.

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But many companies in mid and lower tiers of the defense supply chain will likely be either financially unable or unwilling to weather the storm. Executives see Washington headed for yet another year of budgetary games of chicken and stopgap funding measures, and their reaction is a collective, "uh-oh."

The usually reliable guideposts for determining where the business is headed are nonexistent today. The Obama administration proposed a defense budget for next fiscal year that ignores the 2011 deficit-reduction law. The House and Senate each unveiled its own budget blueprints that reflect ideologically divergent views on how the nation should balance spending against revenues.

Anyone trying to discern the direction of defense spending is left shaking his head, says Jim Stein, vice president of government affairs at SCHOTT North America. The company, which manufactures high-tech glass and other materials used in military equipment, is a subsidiary of Germany-based SCHOTT Group.

Pentagon spending reached its peak in 2010 and has been falling since as a result of sequester and the end of two major wars. In the long term, the cutbacks are expected to be less draconian than previous post-war military downturns. While up and down cycles are the norm in the defense business--and companies adjust accordingly--it is the political environment that is causing angst.

"It's affecting us in how we look at the defense market," says Stein, a former Navy officer who spent many years in the Pentagon. "When you see three budgets out there and so much uncertainty ... that is a lot of churn for us."

Companies such as SCHOTT, whose business does not depend entirely on government contracts, are increasingly questioning whether to invest in military-focused technology or even whether they should continue to do business with the Pentagon. In the current environment, research-and-development funds most likely will focus on products that have commercial applications. This is, "unfortunately, to the detriment of the war fighter," Stein says.

No one should be surprised that companies choose to not pursue expensive ventures that are aimed at the defense market. Midsize and small firms, Stein says, are "hunkered down, trying to...