Being the small player in the payday lending business has had some advantages for QC Holdings (NASDAQ:QCCO), which sports a market cap of just $291 million.

Although subject to the same regulations that affect industry leader Advance America (NYSE:AEA) or First Cash Financial (NASDAQ:FCFS), a pawnbroker that has a large payday lending side in its business, QC Holdings stays under the radar of most critics who look to make examples of the larger players.

QC Holdings has shortcomings based on its size. Even with about 500 storefronts opened for making loans to customers, and focused as it is on making payday loans and providing a few ancillary services, costs involved in expanding tend to affect its operations more heavily than they do larger rivals.

It also depends to a greater degree on the economy, should it sour and more of its consumers default on the loans. The bulk of the company's stores are in Missouri and California, but in states like Illinois that have around 25 branches, state regulatory changes can have a big impact, too.

This year, for example, the total value of loans originated increased 1.3% in the third quarter, but average fees generated by those loans declined to $53.32 from $54.43 in large part because Illinois had mandated lower rates. It imposed a 23% reduction of fees charged per $100 borrowed, to $15.50 from $20.32. Other states like Kansas have also imposed new restrictions, causing the company to realize lower fees despite higher volumes.

Expand to grow
What QC Holdings has found, however, is that once its branches are established for a year or more, the revenues they generate tend to grow. New branches experienced loss ratios exceeding 37% in their first 12 months of operations.

A large part of the payday lender's plans for growth hinge on its ability to expand through opening new branches or acquiring existing storefronts and keeping them open long enough to pay off the costs associated with their opening.

While expansion is costly, the company expects to be able to fund the growth from existing cash flow, even as operating cash flows declined year over year. The lower operating cash flows were due to QC Holdings receiving tax benefits in 2005 from management exercising stock options, which should have pointed up some of the problems the company was going to face in 2006. So while the share price has increased by 29% this year, it was probably due more to the theory that a rising tide lifts all boats.

QC Holdings is undergoing intense competition in one of its bigger markets -- California -- and faces more expenses as it opens new stores. It is richly valued on a price-to-earnings basis whether you're looking backward or looking forward, and its enterprise value-to-EBITDA ratio is the highest in the industry.

Small can be good sometimes because it can allow an investor to get in before the crowd. It's what Motley Fool Hidden Gems seeks to do by finding undervalued, unnoticed small-cap stocks before they take off. QC Holdings doesn't seem to fit that mold. Certainly it's small, but the quality of its earnings, particularly as it faces a difficult and challenging future, would argue against an investment at this time.

While I find the payday lending and pawnbroker business to be both interesting and attractive for investments now -- even after a year of phenomenal industry growth -- I think QC Holdings has been the beneficiary of industry largesse, and 2007 might not prove to be a banner year.

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Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.