You're mostly correct. The data is encrypted, and then broken into a base-4 string. The least significant base-4 bit is dropped from each pixel leaving 98.4% fidelity, which is higher fidelity than the compression that gets applied. Thus in terms of image quality, the picture is indistinguishable from any other compressed image.
The encoding is deliberately reversible and also open-sourced. However, you can apply the same algorithm to any image, whether it's a decoy or not, and get a string of possibly-encrypted-data. The only confirmation that the data is meaningful would be a successful decryption which is only possible with the correct passphrase.
All that said, the fact that the picture is indistinguishable from other non-decoy images only adds a trivial amount of entropy to the encryption. An attacker who is determined to brute force their way into your pictures can simply attempt to crack every picture in your camera roll, decoy or no.
Does it change the low bits of white (0xFFFFFF) pixels? It would be a dead giveaway to find noise in overexposed areas of a photo, at least with the cameras I've used.
Information security is a pretty big passion of mine; I don't think someone needs to have "something to hide" in order to make use of digital signing, encryption, etc. Another passion of mine is making things easier for other people to do. I've written a couple of tools that I think can be useful for the LW crowd.
Online PGP Signature: This is an online javascript-based tool which allows you to sign messages using your PGP private key. I love the idea of PGP-signed messages (I remember someone under the pseudonym "Professor Quirrell" handing out PGP-verified Quirrell points a few years back). The problem is, I had yet to find an easy way to do this that didn't involve downloading command-line based software. So I wrote this tool that uses open-sourced, javascript-based PGP libraries to let you easily sign messages in your browser.
The whole thing is client-side so your private key is never seen by me, but be smart about security. If you don't trust me, that's fine, just don't use the tool. But also remember that you could have a virus, your computer could be monitored, someone could be watching over your shoulder, etc. so please be smart about your security. But hopefully this can be helpful.
Decoy: an iPhone App: I wrote this after "The Fappening", where I was basically appalled at the terrible security practices that pretty much everyone uses when sending pictures back and forth. Decoy uses a combination of steganography and AES encryption to let you send images back and forth without having to sign up for an account or use some outside service that can be hacked or otherwise compromised.
You take the original picture, then you come up with a passphrase, then you take a "decoy" picture. The original picture is converted to base64 image data, which is then AES-encrypted using your passphrase. The resulting cipher text is then encoded into the pixels of the "decoy" picture, which is what gets saved on your phone and sent out. The "decoy" pictures are indistinguishable from any other picture on your or your recipients' camera rolls, and unless you have the passphrase, then the original image is thoroughly inaccessible.
If your phone is lost, hacked, stolen, or (more benignly) someone happens to be looking through pictures on your phone, all anyone will see are the "decoy" pictures. Without the password, those pictures are worthless. Although the app is primarily branded for, *ahem*, "personal use", there are plenty of other ways to use it. For example, my wife and I use it for things like sending pictures of sensitive physical documents like credit cards, birth certificates, social security cards, etc.
(full disclosure: although Decoy is free, it is ad-supported so I do financially benefit from people using the app. But on the bright side I'm an avowed rationalist and if I make a quajillion dollars with this app I will spend the vast majority of it on LW-friendly causes!)