Imara Africa Securities believes that operating in the continent’s microfinance industry can be sustainably profitable, if the business is managed correctly. The company sees good potential in Botswana-listed Letshego Holdings.

SKS Microfinance Ltd., the Indian microlender backed by Sequoia Capital, plans to raise about US$250 million in the first IPO by a financier for the nation’s poorest people and the world’s largest microfinance market.

About 120 million households in India don’t have access to banking and financial services, leading to an untapped credit demand of 1.2 trillion rupees, according to a report by Crisil Ratings.

This comes, as reports Bloomberg, in the context of an industry which while credited with helping to alleviate poverty is coming under growing pressure to tighten loan standards and avoid increasing bad debts.

Sanjay Sinha, managing director of Micro-Credit Ratings in New Delhi, goes so far as to say, “In the U.S., homeowners were given loans at 120% of the value of their properties. In rural India, people are being lent to at 150% of the value of their enterprises,” in drawing a parallel to the potential problems microlenders could face if they do not manage their loans books more closely.

With similar dynamics in terms of a large population that has limited or no access to formal banking channels, Africa’s low banking penetration levels have also led to the establishment of a microlending industry.

One of the better known participants in the sector in Africa is Blue Financial Services, which unfortunately exhibited the traits warned against above, as it reported a loss of R1 billion in the year ended February 2010. This came as impairments increased year-on-year from 10% of the gross loan book to a massive 25%.

It is not all bad news on the microfinance front, however, as we still feel that if managed properly, operating in this industry can be sustainably profitable.

This is shown by one of our favourite stocks, Letshego Holdings, which is listed in Botswana. With a credit model largely based on lending to civil servants and payroll deductions of loan repayments at source, the company has been able to keep its impairments at 3%, lower than many commercial banks, and has thus far managed to balance the desire to grow with an element of prudence.

We question the long term sustainability of the funding model (reliance on raising long term paper from the markets as well as from shareholders as per the recent rights issue) and believe the company will eventually look to become a deposit taking institution thereby mitigating the need to continuously seek these funding lines for growth to continue. With a target price of P2.60, versus its current price of P2.00, we maintain our BUY recommendation.