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Although marked as 'unfinished' it does seem to back yup your observation ... executing the transform is performed using an XmlReader that traverses the whole document.
"Performing the Transformation
Once the stylesheet is fully loaded, XslCompiledTransform can transform the input document. Transformation of the input document to output involves the following steps:
Parsing the input document and building an in-memory XML tree representation for it.
Transforming the input XML tree to the output tree.
Serialization of the output tree.
To load the cache, XslCompiledTransform uses XmlReader to read the input document. At this time, XslCompiledTransform applies whitespace stripping rules.
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