Is Target’s Move to Price Match a Mistake?

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Physical retail has been struggling, dealing with the dreaded “showroom” effect and online retail’s ever increasing grasp. Target (NYSE: TGT) has decided to take the battle to online retailers like Amazon (NASDAQ: AMZN), extending its holiday price matching to a year-round affair. One thing is clear: Storefront retail is struggling to keep pace with its online competition, but is price matching a viable solution?

The first thing to come to mind any time I see price matching is Bertrand competition. In the simplest scenario, two companies compete on the price of a particular good, with the assumption that consumers will simply buy from whomever has the lowest price. The resulting price is equal to the marginal cost of the good, leading to zero profit if both have the same cost structure. When one company has a lower cost structure, the other only has two choices, avoid competing on price or close their operation.

If you apply that construct to Target’s move toward year-round price matching the conclusion is grim. Target is forced to sell goods at Amazon’s prices but lacks the competitive advantages Amazon relies on, ushering in its own demise. Without being able to drop retail operations (and the costs associated with them), price matching simply isn’t a sustainable option. If a price war is what Target is after, I’d argue they’ve picked the wrong opponent.

Fallen retailers like Circuit City can attest to the enormous pressure exerted by online retail, as can currently struggling retailers like Best Buy (NYSE: BBY) and Barnes & Noble (NYSE: BKS). The brick and mortar book seller struggled against Amazon, both on the retail front and more recently in the e-reader market. Despite successfully launching its own e-reader, Barnes & Noble is still struggling against the scope and pricing power of the online juggernaut. It doesn’t help that the e-reader market is being squeezed by the tablet market, with e-reader shipments dropping 36% last year alone. Target isn’t yet in the same predicament as Barnes & Noble, but the struggling bookseller should serve as a warning. Competing head to head with Amazon (and more generally Internet-based retail) is a grim proposition.

Price wars can be effective, but as illustrated by the aforementioned scenario the winner is the company with the cheapest cost structure. As you can see in the chart below, Amazon already operates at a lower margin. 

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AMZN Operating Margin TTM data by YCharts

Add in the fact that the online retail model confers cost advantages over traditional retail, and it is clear Amazon would welcome a price war with Target. Lending credence to that is the fact that Amazon also has higher inventory turnover than Target. Not only is Amazon better positioned for a price war, it is geared towards it and has a much faster inventory turnover rate. Volume is a key factor for low margin businesses, and Amazon is already ahead on that front as well.

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TGT Inventory Turnover TTM data by YCharts

To their credit, Target isn’t going into it without a plan. The company has already outlined multiple exclusions and likely won’t hesitate to add more to avoid exploitation. The full list can be found here, but here are the highlights:

  • No price matching third parties
  • Clearance, closeout, damaged product, refurbished, open package or liquidation sales
  • Buy one, get one if the retail price is not shown in the advertisement
  • Mail-in offers or instant rebates
  • Excludes matching certain ads, including Black Friday sales

With these kinds of restrictions in place, it appears Target’s price matching may be more gimmick and less all out price war, but only time will tell. In any event, it’s hard not to wonder what else Target has planned. One thing is certain, if the only plan is to fight on the competition’s terms, Target may have made a serious misstep. 

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