another case of arduino not being right for the job
I think MP3 encoding can be achieved on an ARM processor, using https://datatype.helixcommunity.org/
check out http://embdev.net/articles/ARM_MP3/AAC_Player which does decoding using the same software
You can use another ARM chip with USB host capability if you want to use USB mass storage disks instead, I think a LPC1768 may be a good starting point as opposed to the AT91SAM7, try a mbed