MBSB’s 3Q15 results missed estimates as credit cost was higher than expected following a one-off full provision for a legacy account. Maintain NEUTRAL and MYR1.65 TP (2% downside). Overall, the move to turn into a full-fledged Islamic financial institution should be a longer-term positive for MBSB but investors will need to exercise patience as regulatory costs would dampen medium-term returns.

3Q15 results miss expectations. Malaysia Building Society’s (MBSB) 3Q15 net profit of MYR64m (-67% YoY, -26% QoQ) missed our and consensus expectations, with 9M15 net profit of MYR273m (-56% YoY) making up 65% of our and 62% of consensus full-year estimates. There was a lumpy loan impairment allowance of MYR35m relating to a legacy account that was booked during the quarter. Hence, 9M15 annualised credit cost of 160bps exceeded our assumption of 142bps for 2015.

Loan and deposit growth. Loan growth was broadly stable (+1% QoQ, +4% YoY), driven by working capital loans to small and medium enterprise (SME) and corporate segments. Meanwhile, customer deposits eased 1% QoQ (+4% YoY), resulting in the loan-to-deposit ratio (LDR) rising to 107% from 106% as at end-2Q15 (3Q14: 108%).

Asset quality. Absolute gross non-performing loans (NPLs) ticked up 2% QoQ (+4% YoY) but the gross NPL ratio was stable QoQ at 6.4%. With the higher provisioning, loan loss coverage strengthened further to 88% from 81% at end-2Q15 (3Q14: 71%).

Briefing highlights. With the higher loan provisioning in 3Q15, MBSB now thinks 2015 credit cost would be closer to 200bps than the earlier guidance of at least 150bps, but 2016 credit cost could be lower than the earlier 100-150bps estimate. MBSB also shared that there may be a manpower rationalisation exercise in 4Q15 to improve efficiency. Finally, management could not share much on the potential merger with Bank Muamalat except that the due diligence process is ongoing and MBSB hopes to wrap up negotiations by end-2015. Notwithstanding the merger, a capital-raising exercise will still be required at some point.

Forecasts and investment case. We cut our 2015 net profit forecast by 20% on the back of higher credit cost assumption of 171bps (vs 142bps previously). Our 2016-2017 projections, however, are relatively unchanged. There is no change to our GGM-derived TP of MYR1.65 following the earnings revisions and a roll forward in valuations to 2016 . Our GGM assumes: i) COE of 12.1%, ii) ROE of 11%, iii) long-term growth of 4%, and iv) 2016F BV/share of MYR1.88. Maintain NEUTRAL.