You are correct that the 7.1 Direct input is converted to digital and back to analog - unless all speakers are set to large, in which case it becomes an analog bypass.
When I first got the 990, I put it in the place of my old Model 950, which used a multichannel analog input that was an analog-only signal path. Using the same source with both processors, I could not hear any degradation with the 990 even with the A/D/A conversion. I wouldn't say that such is likely to be true for all cases - if you have a good enough analog source, you might start to run into some degradation.