He may be positioning himself to be bought out of the market by you. Keep your nose to the grindstone and get market share by making customers very happy they are with you.
Can you explain that more? You have to imagine that customers who are paying nothing for his product (except to be annoyed by "ONE WEIRD TRICK" ads) will be happy to have an alternative, but if they get the same basic functionality, won't they be glad they don't have to pay?
You very well lose customers if price is their pain point, but my point was to win them over with service and marketing and keep that competitor in obscurity. Or offer to buy him out so you can shut his site down.
Got it. That makes sense. We can't beat 'free' on the price point, that's for sure. But we -can- offer support, spend money on marketing, and hope that our existing platform keeps him in the dark.