It is compositing as final step. I understand that the Kuala it is compositing may have been a previously un-existent Kuala that it synthesized from a library of previously tagged Kuala images... that's cool, but what is the difference really from just plucking one of the pre-existing Kualas into the scene?

The difference is just that it makes the compositing easier. If you don't have a pre-existing image that would match the shadows and angles you can hallucinate a new Kuala that does. Neat trick.

But I bet if I threw the poor marsupial at a basket net it would look really differently than the original clipart of it climbing some tree in a slow and relaxed manner. See what I mean?

Maybe Dall-E 2 can make it strike a new pose. The limb positions could be altered. But the facial expression?

And if the basketball background has wind blowing leaves in one direction the Kuala fur won't match, it will look like the training set fur. The puddle won't reflect it. 'etc.

This thing doesn't understand what a Kuala is like a 3-yr old. It understands the text "Kuala" is associated with that tagged collection of pixel blobs and can conjure up similar blobs unto new backgrounds - but it can't paint me a new type of Kuala that it hasn't seen before. It just looks that way.