We maintain our NEUTRAL call and MYR1.65 TP. A potential merger between MBSB and Muamalat would create the second largest Islamic banking group in the country, although the gap to leader, Maybank Islamic, will still be significant. Cost synergy is a possible merger benefit while asset quality and deposit gathering are potential areas the merged entity may need to address.

• Merger with Bank Muamalat (Muamalat) on the cards? Malaysia Building Society (MBSB) announced yesterday that Bank Negara has given the nod for MBSB to commence negotiations with the shareholders of Muamalat, ie DRB-HICOM (DRB MK, NEUTRAL, TP: MYR1.18) and Khazanah Nasional, for a proposed merger of MBSB and Muamalat. BNM requires the negotiations to be completed within three months. Potentially second largest Islamic bank in the making. MBSB has been on the lookout for potential candidates to undertake a corporate exercise. The key criterion is that the potential candidate has to be an Islamic bank, to be consistent with MBSB’s plan of turning into a fully compliant Islamic financial institution within five years. MBSB is double the size of Muamalat in terms of total assets and loans. We estimate that the enlarged entity would be the second largest Islamic bank in the country, behind Maybank Islamic. The loan mix of both entities is mainly retail-based. Muamalat’s asset quality is better, although loan loss coverage levels are broadly on par. We note that the retail deposit base of both entities is low, ie. 7-8% of total deposits. Thus, the merged entity may need to compete aggressively for retail deposits ahead in order to meet regulatory requirements on liquidity. Also, the CASA ratio for the merged entity is low, at 9%.
• Financials. Muamalat’s FY15 (Mar) ROE was 5%. Among the banks, Affin Holdings (AHB MK, NEUTRAL, TP: MYR2.15) has the closest ROE – 2015F of 5.7%, and trades at a 2015F P/BV of 0.55x. Ascribing a fair P/BV of 0.5x, we estimate the acquisition could cost MBSB c.MYR930m.
• Assuming the acquisition is via a share swap with MBSB shares issued at the current share price (see Figures 5 and 6 for other assumptions), we estimate the acquisition could enhance our 2016F-2017F net profit by 15-17%, but EPS would be diluted by 8-10% – while ROE could fall to 11.3-11.5% from 11.5-12% currently.
• Forecasts and investment case. No change to our earnings forecasts, GGM-derived TP of MYR1.65 and NEUTRAL call. Our GGM assumes: i) COE of 11.5%, ii) ROE of 11%, and iii) long-term growth of 4%.