Why Wal-Mart needs its big boxes to win online

December 1, 2011, 10:00 AM UTC

FORTUNE — Wal-Mart launches its latest weapon today in the battle to win online shoppers — Shopycat, a social app that makes gift selections for friends, family or anyone connected through Facebook based on their interests and profile.

Certainly the war of the Big Box retailers is over and Wal-Mart won, hands down. But in the war for online sales, Wal-Mart’s greatest adversary may be itself as it attempts to get its 3,800 U.S. stores and millions of employees working together with Walmart.com. Although the retailer is taking steps in the right direction — Shopycat its latest — it still has a long way to go.

As online sales have soared overall, Wal-Mart (WMT) shoppers have failed to flock to the web in any sizeable number – online sales are estimated to account for just 2% of its revenue according to Deutsche Bank Securities, or about $8 billion. By comparison, Amazon’s revenue leapt 40% in 2011 from the year prior to $34.2 billion.

That’s why Wal-Mart has a renewed focus on leveraging its massive bricks-and-mortar presence to re-invent itself online. That means pushing customers to pick up online orders at Wal-Mart’s stores, crediting store teams with online sales to turn them into a digital sales force and potentially delivering items purchased online from the local Wal-Mart, hitting Amazon and other e-tailers on their speed of delivery. And it also means a hybrid of online apps and digital tools — but only when they fold in with offline too.

“There’s a lot of value that we get online and a lot of value in the physical store, and at the end of the day we expect the best of both worlds,” says Venky Harinarayan, who heads @WalmartLabs. “It’s not going to be one channel.”

Harinarayan’s division, @WalmartLabs, is what most people think about when they consider Wal-Mart’s future. The Wonka-esque digital outpost launched from Wal-Mart’s $300 million purchase of a social advertising hybrid Kosmix in April. There, engineers are busy churning out social shopping apps, such as Shopycat, which makes gift recommendations by data-mining Facebook profiles. Next up are a raft of social apps that will let customers connect with each other and to Wal-Mart staff, as well as find products or ideas when they are physically in a Wal-Mart store.

But even if @WalmartLabs is wildly successful, social apps alone won’t make Wal-Mart an online contender. If the retailer wants to win online, it will happen because — and not in spite of — its physical boxes.

“What Wal-Mart has is thousands of distribution points around the country with their stores, and that’s their advantage,” said Charles Grom, a retail analyst with Deutsche Bank Securities in New York. “I don’t think they have a lot of time to experiment with @WalmartLabs and they need to move quicker than they are.”

To grow its online revenues, e-commerce needs to be prioritized into the Big Box culture. But that will be a huge shift from the way Wal-Mart has been run up until now.

“We didn’t talk about dot-com in the stores,” says Joel Anderson, who took the helm as president of Walmart.com less than four months ago after serving as SVP of Wal-Mart’s northern plains division. “And you’ve got to make it top of mind, so when we’re out of stock in the store, the very next sentence is we can get that for you online. When that’s part of incentive pay and bonus, it changes [store employees] behavior.”

Starting in February, Wal-Mart will credit team members with online sales picked up in stores, and also online sales delivered within a store’s set physical area. Anderson says half of online orders are now picked up in stores. Shipping also integrates online and stores more, by effectively turning Wal-Mart stores into distribution hubs. Web orders can be shipped to a store or a FedEx location for free, shipped to a home, or, on eligible items, picked up that day from a store. “Fast, faster, fastest,” is the new policy.

Imagine cotton sheets ordered by a customer in Elkhorn, Ne. in the morning, arriving that afternoon from one of its Omaha Supercenters just a few miles away. Same day shipping is the Mecca of online commerce – only a few brands, such as Nordstrom (JWN) and Barnes & Noble (BKS), have tried it in select cities. Anderson says the retailer is looking at that option — but still won’t commit. At least for now.

“We’re experimenting with that, but it’s not in a rolled-out format,” he says. “It’s a possibility.”

Free shipping is another service that consumers want, but Wal-Mart has yet to adopt completely. Still, three out of four customers would make more purchases online if their orders were shipped free, according to the Boston-based online behavior research firm, Compete. But Wal-Mart is still hesitating on that as well.

“To the home isn’t 100% [free shipping,] but it’s getting darn close,” says Anderson. “I get that free shipping is important to the customer.”

Wal-Mart is preparing for the end of the Big Box era. Although it still plans to open more stores in the U.S., even Wal-Mart notes these “are smaller than the larger Supercenters we’ve built in the past,” said Karen Roberts, president of Wal-Mart Realty during its shareholder and analyst call in October. And this comes as pure-play etailer Amazon (AMZN) launched its first storefront called Beauty Bar in Long Island, NY this fall. While not branded Amazon, it’s a toe in the water towards a hybrid model that Wall Street is eyeing closely.

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