How Amazon can beat Wal-Mart's pricing game
Instead of fighting a price war it can't possibly win, the online retailer should back off and cede the low ground.
NEW YORK (Fortune) -- As it faces down Wal-Mart in a book price war, Amazon could take a few lessons from Toys "R" Us.
What once was the world's largest toy retailer got into big trouble in 2003 when it tried to beat Wal-Mart on pricing. Wal-Mart (WMT, Fortune 500) dug in and rolled over Toys "R" Us like a Panzer tank. By the end of that holiday season, Wal-Mart was undercutting its rival on some popular toys by as much as 90%.
Toys "R" Us eventually shifted its strategy to focus more on exclusive products and services, as opposed to price alone. But the price wars that season took a toll on the whole industry, helping to send rival retailers KB Toys and FAO Schwartz into bankruptcy.
The lesson: "It's very tough to beat Wal-Mart at its own game," says Craig Johnson, president of Customer Growth Partners, a consulting firm.
Amazon (AMZN, Fortune 500) looked like it was ready to make the same mistake. When Wal-Mart slashed the price of 10 soon-to-be published books by big name authors to $10 apiece last week, Amazon quickly matched that price. Wal-Mart then moved even lower, to $9. Amazon matched again. Then Target (TGT, Fortune 500) jumped in with an $8.99 price. And so Wal-Mart went lower yet again, to $8.98.
"It's stupid to do battle with Wal-Mart on the basis of price," says Ed Weller, an analyst with ThinkEquity. "There's no way you can win."
So how does a retailer faced with an onslaught of price cuts by Wal-Mart reach détente? Weller suggests ceding the low price ground to Wal-Mart -- but only by a few pennies. In the case of books, it's doubtful that consumers will differentiate between Wal-Mart's $8.99 price and the penny more that Amazon is charging. But Wal-Mart gets to claim low price status, which should appease the retailer for now.
It's a lesson Target has mastered. The discount retailer frequently prices products a few pennies higher than Wal-Mart, allowing it to stay competitive while avoiding direct price competition, Weller says.
The book salvo is just one shot in what promises to be a very aggressive holiday season for price competition. Wal-Mart unveiled plans on Wednesday to roll back prices on a weekly basis for a range of frequently purchased items, including ground beef, bananas and Spring Valley vitamin C.
The announcement, which will place even more pressure on grocery and dollar store retailers, came during a two-day meeting with analysts at its Bentonville, Ark. headquarters, where Wal-Mart announced a variety of initiatives.
The discount retailer also said it wants to be a leader in all entertainment products. Of particular interest, analysts say, are digital downloads of movies, which will place it in more direct competition with companies like Netflix.
"I'm competitive in nature and I want to win," CEO Mike Duke told analysts in his opening remarks.
But a win for Wal-Mart doesn't necessarily mean a loss for the competition. After its disastrous battled with Wal-Mart in 2003, Toys "R" Us was purchased by a group of private equity firms.
They installed a new CEO named Gerald Storch, who had previously served as vice chairman of Target. He added more exclusive products so that the retailer didn't compete head-on with Wal-Mart.
In October 2008, when Wal-Mart lowered the price of 10 popular toys to $10 a piece, Toys "R" Us was ready. The toy retailer responded by lowering prices on key items so that it stayed competitive with Wal-Mart, but it also played up exclusive products such as a new line of Hot Wheels from Mattel that weren't available at Wal-Mart stores.
For a Wal-Mart competitor, winning never tasted so sweet. 
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