We retain our NEUTRAL call with a revised MYR1.65 TP (4% downside). Its 2Q15 results missed estimates as credit cost was higher-thanexpected – a reflection of the group’s ongoing move to raise loan provisioning standards. While this should result in improved loan loss coverage levels ahead and ease concerns regarding asset quality, its bottomline is likely to stay subdued in the near term.

2Q15 results miss expectations. Malaysia Building Society’s (MBSB) 2Q15 net profit of MYR86m (-63% YoY, -31% QoQ) missed our and consensus expectations, with 1H15 net profit of MYR210m (-51% YoY) making up just 43% of our and 40% of consensus full-year estimates. Loan impairment allowances were higher than expected (1H15 annualised credit cost of 132bps vs our earlier assumption of 116bps) as MBSB continues to move towards more stringent provisioning standards relating to its non-performing loans (NPLs).

Loan and deposit growth. Loan growth picked up pace (+1.5% QoQ/+4% YoY) thanks to working capital loans to small and medium enterprise (SME) and corporate segments. Meanwhile, customer deposits jumped 9% QoQ (+2% YoY) led by growth in fixed deposits , resulting in the loan-to-deposit ratio (LDR) declining to 106% from 114%as at end-1Q15 (2Q14: 104%).

Asset quality. Absolute gross NPLs ticked up 4% QoQ (-4% YoY) while the gross NPL ratio inched up 20bps QoQ, at 6.4%. Loan loss coverage, however, improved to 81% from 78.5% at end-1Q15 (2Q14: 67.3%).

Briefing highlights. MBSB said the higher collective allowances made in 2Q15 stemmed mainly from the retail segment after a reassessment of both PD and LGD methodology. In terms of its plan to be a full-fledgedIslamic Bank, MBSB thinks that the bulk of the required Islamic banking platform is already in place. Its conventional books will need to be converted to the Islamic platform, but this should not be an issue. Lastly, MBSB is not in talks with Bank Muamalat on a potential deal.

Forecasts and investment case. We cut our 2015 net profit forecast by 15% mainly on the back of higher credit cost assumption of 142bps (vs 116bps previously). Our 2016-17F projections, however, are relatively unchanged. Our GGM-derived TP drops to MYR1.65 from MYR1.70following the earnings revisions. Our GGM valuation assumes: i) a cost of equity of 11.5%, ii) ROE of 11%, iii) long-term growth of 4%, and iv) 2015F BV/share of MYR1.76. Maintain NEUTRAL.

Briefing Highlights Increase in 2Q15 collective allowance (CA) due to reasses sment of provisioning models. 2Q15 credit cost rose to 149bps from 114bps in 1Q15, largely due to a higher CA. Management attributed this to a reassessment of its probability of default (PD) and loss-given default (LGD) methodology. Management retained its2015 credit cost guidance of at least 150bps while a more normalised credit cost going forward was expected to be <50bps.

Move to turn into a full-fledged Islamic financial institution. MBSB believes the bulk of the required Islamic banking platform is already in place. Some conversion of the current conventional facilities to Islamic banking facilities will be required but MBSB does not think this would be a problem as: i) Islamic banking assets already form 85% of total assets as at Jun 2015; and ii) MBSB has already been more focused in pushing out Islamic banking products since last year. As for regulatory requirements, management does not discount the possibility that Bank Negara could grant MBSB some extra time to meet with some of the requirements. Update on capital-raising. More details should be available later this year, but MBSB’s major shareholder is supportive of the exercise. To an extent, the amount raised would depend on whether any corporate exercise materialises.Potential corporate exercise with Bank Muamalat. Management said MBSB was not in talks with Bank Muamalat.

Risks The risks include: i) slower-than-expected loan growth, ii) weaker-than-expected NIMs, iii) deterioration in asset quality, iv) further regulatory measures to rein in household debt; and v) a larger-than-expected capital raising exercise.

Forecasts We raised our 2015F credit cost assumption to 142bps from 116bps due to the higher-than-expected credit cost in 1H15. Our credit cost assumptions of 84bps/59bps for 2016F/2017F are relatively unchanged. Overall, we cut our 2015 net profit forecast by 15%, while our 2016-2017 net profit projections have been lowered by 1-2%.

Valuations and recommendation We lower our GGM-derived TP to MYR1.65 from MYR1.70 following the earnings revisions above. Our GGM assumes: i) COE of 11.5%; ii) ROE of 11%; iii) long-term growth of 4%; and iv) 2015F BVPS of MYR1.76 (from MYR1.79). While the move to turn into a full-fledged Islamic financial institution should be a longer-term positive for MBSB, investors will need to exercise patience as earnings and returns may not be exciting in the medium term. Chiefly, this will be due to regulatory costs that MBSB will need to comply with in order to achieve the status of Islamic bank. Already, loan impairment provisioning has ticked up due to more stringent provisioning standards being adopted. Other potential costs of compliance we see ahead include capital as well as liquidity. No change to our NEUTRAL recommendation.