Every year, the United States government doles out $6 billion in military foreign aid to U.S. allies. Granted, much of this aid comes with strings attached -- requirements that the money be spent buying weapons from U.S. defense contractors such as Northrop Grumman (NYSE:NOC) and Lockheed Martin (NYSE:LMT). But hey, it's still free money!

But perhaps not for long.

Two F-5 Tiger II aircraft's flying.

Northrop Grumman won $60 million to upgrade old Tiger II fighter jets for Tunisia in 2013. But what if those planes had never been sold? Image source: Northrop Grumman.

As The Wall Street Journal reported last week, President Donald Trump is moving to transform many of America's foreign military aid "grants" into foreign military aid "loans." Curiously, this transformation will not affect aid to countries that could easily afford to repay a loan, such as Israel (recipient of $3.1 billion annually), or those that will soon become able to repay a loan because they'll be swimming in oil money (like Egypt -- a $1.3 billion beneficiary of State Department largesse).

Rather, grants will become loans for dozens of down-at-the-heels military customers such as Pakistan, Lebanon, and Ukraine. And this development has the potential to blunt earnings growth at some of America's biggest defense companies.

A new $1 billion loan portfolio

According to the WSJ, $1 billion in annual military aid grants are at risk of being transformed into loans going forward. So what does this mean for the defense industry?

An internal State Department memo reviewed by the WSJ notes, "The vast majority of countries that receive [military aid grants today] would not desire to take out, or would not qualify for an international loan." As a result, there's a very real risk that sales, which would ordinarily result from a grant of foreign military aid, will not materialize in the future if all the U.S. offers is a loan. After all, a country receiving a loan is spending its own money. It will therefore be tempted to comparison shop between cheaper, state-subsidized weapons systems from Russia or China -- and maybe not buy from the U.S. at all.

To put this effect into concrete terms, the eight Lockheed Martin F-16s that Pakistan ordered earlier this year -- a sale valued at $565 million -- might not have happened if the U.S. had offered Pakistan military aid loans instead of military aid grants. Likewise, the $26 million contract that Orbital ATK (NYSE:OA) won to militarize a commercial Cessna 208B Caravan for Lebanon last year may not have happened. You could also probably scratch last year's sale of $9 million worth of Raven drones from AeroVironment (NASDAQ:AVAV) to Ukraine.

These, and hundreds of millions of dollars worth of similar contracts, would all have been imperiled by a U.S. government switch to awarding military aid loans instead of military aid grants. If the switch is enacted, future years could see U.S. defense contractors lose billions of dollars of potential sales.

The snowball effect

That's only the beginning of the defense industry's problems. When a U.S. defense contractor sells a new weapons system abroad, it doesn't just collect revenues from that sale. It also establishes an "installed base" of equipment with a foreign client -- equipment that can keep on generating sales of maintenance services and upgrades for decades.

For example, in 1981 the government of Tunisia ordered a dozen F-5 Tiger II fighter aircraft from Northrop Grumman (NYSE:NOC). More than 30 years later, in 2013, Tunisia invested $60 million more in upgrading the avionics on those old Tigers for continued military service. Those $60 million in sales wouldn't have happened for Northrop if, for example, Tunisia had bought (or been granted) cheap Soviet MiG aircraft back in the '80s.

If a switch from foreign military aid grants to foreign military aid loans takes place, similar contracts for upgrades may never happen at all.