It actually modifies the photo, but the original photo is kept so the watermark can be changed in the future, and other manipulations can take place. If an image is watermarked, the manipulations (crop, flip, rotate etc.) all happen on the original image and then the watermark is reapplied.
Similarly, this allows watermarks to be removed, or reapplied whenever you like.
Not sure if this suggestion should go here, but it would be really nice to also give the option to watermark all photos on XenForo. Maybe users stop uploading photos to the gallery in order to avoid this.