Kinder Morgan (KMI -0.84%) will be exiting Canada after all. The North American energy infrastructure giant was considering several alternatives for its majority-owned Canadian subsidiary Kinder Morgan Canada (KML) earlier this year, including an outright sale or merger. But it chose to keep that entity independent after it didn't find any attractive offers.

That changed this week as the company agreed to merge Kinder Morgan Canada with Pembina Pipeline (PBA -1.06%) in a deal worth 2.3 billion Canadian dollars ($1.7 billion), which includes the assumption of debt and preferred stock. In addition, Kinder Morgan will sell the U.S. section of a cross-border pipeline to Pembina for another $1.55 billion. Those transactions will not only hasten Kinder Morgan's exit from Canada but also provide it with a lot more financial flexibility.

Two people shaking hands with pipelines in the background.

Image source: Getty Images.

Drilling down into the deal

Pembina Pipeline will acquire Kinder Morgan Canada in an all-stock deal. It will exchange 0.3068 of its shares for each share of Kinder Morgan Canada, including Kinder Morgan's 70% stake in the company. At that exchange ratio, Pembina Pipeline is paying a whopping 38% premium for Kinder Morgan Canada based on the closing price of both stocks before the deal's announcement.

Pembina Pipeline will also buy the U.S. portion of the Cochin pipeline from Kinder Morgan for $1.55 billion in cash. That will give it full control over the cross-border pipeline. The system ships condensate to the Canadian oil sands region, where it's mixed with the bitumen produced in the area so that it flows through pipes more easily.

The companies expect both deals to close by the first half of next year.

How the transactions will affect Kinder Morgan

This deal does two things for Kinder Morgan. First, it will enable the company to exit Canada eventually. The pipeline giant began its departure last year when it sold the controversial Trans Mountain pipeline to the Canadian government. While the company will initially receive 25 million shares of Pembina (a slightly less than 5% stake), it ultimately expects to sell those shares for cash. Based on the current market value of both companies, Kinder Morgan would net $935 million in pre-tax proceeds.

The other benefit of this deal is that it will enhance Kinder Morgan's financial flexibility. The company will get $1.55 billion in cash when it closes the sale of the U.S. portion of the Cochin Pipeline. That implies a 13 times EBITDA multiple, which is a premium value considering that Kinder Morgan currently trades at 10.8 times its EBITDA. The company intends to use that money to pay down debt, which will push its leverage ratio down to 4.4 times net debt to adjusted EBITDA by year-end. That's an improvement from its current forecast that leverage will end 2019 at 4.6 times. Meanwhile, Kinder Morgan intends to use the eventual proceeds from the sale of its Pembina stake to buy back stock and invest in new expansion projects.

The transaction, however, will act as a near-term drag on Kinder Morgan's financial results because it will lose the earnings these assets generated. It will be able to partly offset the lost income through a lower interest expense as it pays down debt. And it will benefit from the earnings it receives from its stake in Pembina. Meanwhile, it could eventually more than offset the lost income by using its enhanced financial flexibility to strategically buy back its stock or invest in high-return expansion opportunities.

A good move by Kinder Morgan

"This is an attractive transaction for Kinder Morgan and Kinder Morgan Canada stockholders," Kinder Morgan CEO Steve Kean said. It will reduce leverage, increase its financial flexibility, and simplify its structure by hastening its exit from Canada. While the transactions will hurt earnings growth in the near term, the longer-term benefits from an enhanced financial profile should far outweigh that headwind.