The bad news is that the market for MP3 players is shrinking rapidly. Munster cites NPD data that show year-to-year growth in spending on stand alone players falling from from 131% in 2005 to 17% in 2006 and a contraction of -4% in 2007.

Similarly, Apple saw iPod sale growth rates trail off through 2007, from 50% year-to-year growth in the December 2006 quarter to 5% in December 2007 — the lowest in iPod history. The street is expecting 4% growth in Q2, but given the traditional post-Christmas fall-off in iPod sales, that may be optimistic.

The good news is that Apple’s share of the MP3 player market has remained steady throughout this period (72% of unit sales in ’05 and ’06, 70% in ’07). Moreover, on a dollar-share basis it has been growing, from 71% in ’04 to 84% in 07. During the first month of iPod touch sales, Apple’s dollar share hit an impressive 90%.

What this suggests to Munster is that Apple will have innovate its way out of what is rapidly becoming a replacement market. Like other analysts, he reads much in Tim Cook’s remarks during last week’s earnings conference call, in which Apple’s COO referred to the iPod touch as the beginning of a “mainstream Wi-Fi mobile platform.” Munster writes:

We believe that the iPod touch is the first of several Internet-connected iPods that Apple is currently developing. Internet connectivity enables applications like e-mail and a web browser to add significant value to the iPod lineup, which will drive incremental growth and spur the replacement cycle for current iPod owners. With 70% market share, we believe Apple is positioned to transform the MP3 market into a portable computing market.

Using iSuppli data, Munster estimates that it costs Apple $15 to add a Wi-Fi radio to an iPod and roughly $30 to add a multi-touch screen. And what could you do for that extra $45? Among other things, says Munster, you could buy lattes:

For starters, as we have seen with the iPod touch and the iPhone, e-mail, full-featured web browsing, a mobile iTunes Store, YouTube, and Google Maps are all possible on an iPod. An Internet-connected iPod could even stream content from users libraries hosted remotely, which would eliminate the capacity issues surrounding locally stored media. Another interesting possibility includes additional consumer applications like wireless purchasing for convenience. If for example you are on your way to Starbucks, you could wirelessly order your drink from your iPod, pay for it using your iTunes account or the attached credit card, and pick it up without ever standing in line or waiting at a cash register.