BOSTON — Berenberg Capital Markets L.L.C. has initiated coverage of Flowers Foods Inc. with a “hold” rating.

While Thomasville, Ga.-based Flowers has been gaining share in the baked foods category in recent years, Berenberg warned that the sales growth has been driven by less profitable products, including Dave’s Killer Bread.

Based in Boston, Berenberg is a subsidiary of Joh. Berenberg, Gossler & Co. KG, Hamburg, Germany. Berenberg has a price target for Flowers of $22 per share, about $1.50 per share lower than where the company’s shares were trading at mid-day July 19.

Donald McLee, a Berenberg analyst, summarized the baking category as large ($36 billion in annual sales) and “fragmented.”

“The bulk of that low growth is driven by the traditional bread loaf, which is fairly commoditized,” Mr. McLee said. “However, there are several pockets of elevated consumer demand for specialty items. Flowers is the market leader for organic baked goods, which is a primary underlying growth segment and has become a key differentiator in recent years. The success of its Dave’s Killer Bread brand has helped support nearly 100 basis points of year-over-year expansion for Flowers’ market share in the broader category to 17% in the first quarter of 2019. We expect the strength of the organic category to support further market share gains in the intermediate-term.”

Describing baking as “fiercely competitive,” Mr. McLee said thousands of regional bakers, local bakers and retailer-owned bakers vie for market share.

The three largest baking companies — Grupo Bimbo S.A.B. de C.V., Flowers and Pepperidge Farm, Inc. — account for about 50% of the market, which Mr. McLee noted has been growing very slowly.

“Given the commoditized nature of the traditional bread loaf, price is often the biggest determining factor for purchasing customers,” Mr. McLee said. “This generally makes the traditional bread loaf a lower-margin product, with limited price elasticity.

Against this backdrop, specialty bread has been a preferred avenue for growth.

Mr. McLee said gluten-free bread could be one of the fastest growing segments in coming years, noting that growth since 2015 has compounded annually at a 6.6% rate, well outpacing the overall market. Flowers entered this market with the December 2018 acquisition of Canyon Bakehouse, Johnstown, Colo.

“Canyon Bakehouse gives Flowers a strong foothold into that attractive growth profile via a leading brand,” Mr. McLee said.

Upside for Canyon stems from the broadening customer base for gluten-free products and because 90% of Canyon Bakehouse sales are from frozen products.

“While gluten-free eating is generally considered as being in the ‘mature’ stage of the healthy claims lifestyle, we think there is still solid future growth potential,” Mr. McLee said.

He cited Technomic data indicating 52% of respondents to a 2018 survey believe gluten-free foods are healthier. The number of consumers on gluten-free diets without a gluten disease or sensitivity doubled between 2009 and 2014.

“We also see untapped growth potential for Canyon’s products in the fresh baked goods segment,” Mr. McLee said. “As previously noted, 90% of Canyon Bakehouse sales are derived from frozen products. We believe this is due to the relatively short shelf-life of bread and Canyon’s limited distribution capabilities. We expect Flowers to utilize its superior distribution capabilities and retail partnerships to expand the network for Canyon products and increase sales of its fresh baked goods.”

Berenberg described results from Project Centennial as “mixed at best to date.”

“While Flowers has been able to hit its target of flat-to-2% sales growth in 2018, it has fallen short of its EBITDA margin targets,” Mr. McLee said.

He said the company’s EBITDA margin dropped to 10.4% in 2018, down 110 basis points from two years earlier.

“We think this decline was driven by Flowers’ product mix, indicating that some of its faster growth products (like Dave’s Killer Bread) are likely lower margin,” he said.

Also pressuring margins has been rising input costs, up $40 million in 2018.

“While this was largely attributable to rising ingredient costs (as wheat and flour costs moved higher), management noted that a tight labor market and rising freight costs were also headwinds throughout the year,” Mr. McLee said. “Despite a subsequent input cost decline in the first quarter of 2019, we expect the headwinds from freight, labor and ingredients to continue in 2019. While ingredient cost is a sector wide issue, we note that Flowers only tends to hedge its ingredients over a four to seven-month time horizon (compared to competitors in the 12-month range), which leaves it more susceptible to price inflation for its ingredients.”

Berenberg said the lower margins of higher-growth products create “a vicious cycle in which its sales growth and EBITDA margins are likely in opposition at this point.”

Flowers’ shares could enjoy considerable upside if it is able to achieve higher margins, Mr. McLee said.

“Our bull-case analysis assumes Flowers is able to reach its intermediate-term performance targets such as 13% EBITDA margin and modest volume acceleration,” he said. “Based on our estimates, we calculate a bull case valuation of $34, or about 31% potential upside to the current share price.”