Yep. You got it.
You can use PHP to modify images on the fly.
Let's say you sell downloadable graphics. You want to be able to show off your images without giving them away. You could use PHP to add a layer with a "SAMPLE ONLY" message or a "COPYRIGHT" text across it. Or any other kind of distortion you want to do. All without having to create and store a new image!
Isn't PHP great!
Jack