Why is the compressed backup so large?

This happens because its a full-disk backup, taking a copy of every byte of the virtual disk where its "used" or not.

Over time, your operating system will end up writing data to the entire disk, so while from the filesystem perspective there might be lots of free space, if you looked at the individual blocks of the disk, every one of them will have some data written on it; in some cases most of which is not in use.