VHS is about as low on the totem pole as video can possibly be. It is worse than analog cable, it is far worse than DVD.
I think you get the idea of what is going on with your receiver, but here are a couple of terms to know:
1. Your receiver is TRANSCODING not upconverting. Transcoding takes an input signal in one cable format (composite) and converts it to another cable format (component). It does not analyze the image or perform any sort of upconversion to the video signal. If it looks really bad coming in, it will look really bad coming out. Transcoding.
2. Image Processing is what you thought was going on and that typically is an upconversion process where video will come in in one format (composite, s-video, etc.) and will be analyzed by circuitry that can help reduce noise, clean up edges, boost color, etc. The video that is output can potentially be better and cleaner than the video that came in. Check
www.dvdo.com for products that actually do some image processing and upconversion (scaling).
Yes, a S-VHS VCR with your old tapes may produce slightly better results. If the tapes look really poor, then you may just have some worn out heads on your VCR. Since VCRs actually require the tape to run over the scanning heads, they quite often start to look worse and worse and eventually just have a horrible image. You may want to try to clean the tape heads before buying a new VCR.