<PAGE>

                       SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549

                                   FORM 10-QSB

(X)   QUARTERLY REPORT PURSUANT SECTION 13 OF 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 1998.

( )   TRANSITION REPORT PURSUANT SECTION 13 OF 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from ________ to ________

Commission file number 333-38697

                          PHYSICAL SPA & FITNESS, INC.
           (Exact name of small business as specified in its charter)


             Delaware                              13-1026995
      ----------------------                    ----------------
   (State or other jurisdiction                  (IRS Employer
   of incorporation or organization)             Identification No.)


                          12/F - 15/F Lee Theatre Plaza
                          99 Percival St., Causeway Bay
                                    Hong Kong
                    (Address of principal executive offices)

                              (852) (852) 2572-8888
                           (Issuer's telephone number)

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act during the past 12 months (or for
such shorter period that the registrant was required to file such reports) and
(2) has been subject to such filing requirements for the past 90 days.

                              Yes        No    X
                                  ----        ----

State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable dated : June 1, 1999, 10,000,000 shares.

Transitional Small Business Disclosure Format (check one) :
                              Yes          No   X
                                  ----        ----

<PAGE>

                                TABLE OF CONTENTS



PART I  -  FINANCIAL INFORMATION                                    PAGE
                                                                    ----
   ITEM 1   -   FINANCIAL STATEMENTS

     Consolidated Statements of Operations
     for the nine months and three months ended September
     30, 1998 and September 30, 1997 (Unaudited)                       1

     Consolidated Balance Sheets at September 30, 1998
     and December 31,1997 (Unaudited)                                  2

     Consolidated Statements of Cash Flows
     for the nine months ended September 30, 1998
     and September 30, 1997 (Unaudited)                                3

     Notes to Consolidated Financial Statements                      4 - 14

   ITEM 2   -   MANAGEMENT'S DISCUSSION AND ANALYSIS
                OR PLAN OF OPERATION                                15  - 18


PART II  -   OTHER INFORMATION

   ITEM 1   -   LEGAL PROCEEDINGS                                     19

   ITEM 2   -   CHANGE IN SECURITIES                                  19

   ITEM 3   -   DEFAULTS UPON SENIOR SECURITIES                       19

   ITEM 4   -   SUBMISSION OF MATTERS TO A VOTE
                OF SECURITY HOLDERS                                   19

   ITEM 5   -   OTHER INFORMATION                                     19

   ITEM 6   -   EXHIBITS AND REPORTS ON FORM 8-K                      19



<PAGE>
<TABLE>

                             PHYSICAL SPA & FITNESS, INC. AND SUBSIDIARIES
                      CONSOLIDATED CONDENSED STATEMENTS OF INCOME (UNAUDITED)
                   NINE MONTHS AND THREE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
                 (Amounts in thousands, except number of shares and per share data )
<CAPTION>

                                                   Three months ended September 30      Nine months ended September 30
                                                   1997        1998       1998           1997        1998         1998
                                                 ----------  ----------  ----------    ----------  ----------  -----------
                                                    HK$         HK$         US$           HK$         HK$           US$
<S>                                              <C>         <C>         <C>           <C>         <C>
Operating Revenues
Fitness service                                     24,312      34,212       4,415        55,161      96,856       12,498
Beauty treatments                                   15,829      21,640       2,793        50,862      51,334        6,624
  Others                                                47           9           1           110          52            7
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Total operating revenues                            40,188      55,861       7,209       106,133     148,242       19,129
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Operating Expenses
Salaries and commissions                            10,118      13,694       1,767        26,201      39,385        5,082
Rent and related expenses                            9,551      12,788       1,650        22,659      32,410        4,182
Depreciation                                         4,883       7,162         924        10,974      18,776        2,423
Other selling and administrative expenses            9,224      20,927       2,701        23,542      43,459        5,608
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Total operating expenses                            33,776      54,571       7,042        83,376     134,030       17,295
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Income from operations                               6,412       1,290         167        22,757      14,212        1,834
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Non-operating (income) expenses

Other (income), net                                   (399)        (41)         (5)       (1,653)       (499)         (64)
Interest expenses                                    1,211         848         110         2,460       2,892          373
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Total non-operating (income) expenses                  812         807         105           807       2,393          309
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Income before income taxes and
minority interests                                   5,600         483          62        21,950      11,819        1,525

Provision for income taxes                           1,423      (3,924)       (507)        4,769      (1,524)        (197)
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Income before minority interests                     4,177       4,407         569        17,181      13,343        1,722

Minority interests                                     475         627          81         1,689         960          124
                                                 ----------  ----------  ----------    ----------  ----------  -----------

Net income                                           3,702       3,780         488        15,492      12,383        1,598
                                                 ==========  ==========  ==========    ==========  ==========  ===========

Earnings per common share                             0.37        0.38        0.05          1.55        1.24         0.16
                                                 ==========  ==========  ==========    ==========  ==========  ===========

Number of shares outstanding (in thousands)         10,000      10,000      10,000        10,000      10,000       10,000
                                                 ==========  ==========  ==========    ==========  ==========  ===========


Translation of amounts from Hong Kong Dollars ("HK$") into United States Dollars
("US$") for the convenience of the reader has been made at the exchange rate
quoted by the Asian Wall Street Journal on March 31, 1998 of US$1.00 = HK$7.75.
No representation is made that the Hong Kong Dollar amounts could have been, or
could be, converted into United States Dollars, at that rate on March 31, 1998
or at any other certain rate.




                                 1

</TABLE>

<PAGE>
<TABLE>

                PHYSICAL SPA & FITNESS, INC. AND SUBSIDIARIES
                    CONSOLIDATED CONDENSED BALANCE SHEETS
                    AS OF DECEMBER 31, 1997 (AUDITED) AND
                    AS OF SEPTEMBER 30, 1998 (UNAUDITED)
       (Amounts in thousands, except number of shares and per share data)

<CAPTION>

                                                    December 31,
                                                        1997          September 30, 1998
                                                    --------------   ---------------------
                                                         HK$              HK$        US$
  ASSETS                                                             (Unaudited)(Unaudited)
<S>                                                 <C>              <C>        <C>
Current assets
Cash and cash equivalents                                   1,954        4,817        622
Trade receivables                                           9,573        7,682        991
Rental and utility deposits                                 7,243       10,053      1,297
Prepayments to vendors and suppliers and other             10,826       12,535      1,617
current assets
Inventories                                                 4,022        4,022        519
Due from related companies                                  4,932        7,784      1,004
Due from a shareholder - current portion                    8,414        4,693        606
                                                    --------------   ---------- ----------
Total current assets                                       46,964       51,586      6,656
                                                    --------------   ---------- ----------

Due from a shareholder - non-current portion                2,361            -          -
Prepayments for construction-in-progress                   17,011        6,633        856
Property, plant and equipment, net                        106,846      125,775     16,229
                                                    --------------   ---------- ----------

Total assets                                              173,182      183,994     23,741
                                                    ==============   ========== ==========

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities
Short-term bank loans                                       5,596        7,512        969
Long-term bank loans - current portion                      6,269        4,394        567
Accounts payable and accrued expenses                       8,237       24,213      3,124
Loans from third parties                                    9,741        3,092        399
Obligations under finance leases- current portion           4,577        5,577        720
Deferred income                                            37,696       35,796      4,619
Deferred liabilities                                        5,012        4,455        575
Income taxes payable                                        9,895        5,205        672
Taxes other than income                                     9,880        9,079      1,171
                                                    --------------   ---------- ----------

Total current liabilities                                  96,903       99,323     12,816
                                                    --------------   ---------- ----------

Long-term bank loans                                        6,786        6,591        850
Long-term loans from third parties                              -            -          -
Loans from minority shareholders of subsidiaries            5,160        4,200        542
Obligations under finance leases - non current              8,253        4,750        613
 portion
Deferred taxation                                           4,574        4,291        554
Minority interests                                          6,689        7,652        987

Shareholders' equity:

Common stock, par value US$ 0.001 each, 100
million shares authorized; 10 million shares                   78           78         10
outstanding
Cumulative translation adjustment                             131          118         15
Retained earnings                                          44,608       56,991      7,354
                                                    --------------   ---------- ----------

Total shareholders' equity                                 44,817       57,187      7,379
                                                    --------------   ---------- ----------

Total liabilities and shareholders' equity                173,182      183,994     23,741
                                                    ==============   ========== ==========
</TABLE>

Translation of amounts from Hong Kong Dollars ("HK$") into United States Dollars
("US$") for the convenience of the reader has been made at the exchange rate
quoted by the Asian Wall Street Journal on March 31, 1998 of US$1.00 = HK$7.75.
No representation is made that the Hong Kong Dollar amounts could have been, or
could be, converted into United States Dollars, at that rate on March 31, 1998
or at any other certain rate.

                                       2
<PAGE>
<TABLE>
                 PHYSICAL SPA & FITNESS, INC., AND SUBSIDIARIES
                   ------------------------------------------
           CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED)
           -----------------------------------------------------------
                  NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1998
                             (Amounts in thousands)
<CAPTION>
                                                   1997              1998
                                               ---------      --------------------
                                                    HK$         HK$        US$
<S>                                            <C>            <C>       <C>
Cash flows from operating activities:

Net income                                       15,492         12,383      1,598

Adjustments to reconcile net income to net
cash provided by operating activities:
Minority interests                                1,689            960        124
Depreciation                                     10,974         18,776      2,423
Loss (Gain) on disposal of fixed assets             135            129         17

(Increase) Decrease in assets:
Trade receivables                                 3,648          1,891        244
Deposits, prepayments and other current          (2,459)        (4,519)      (583)
  assets
Inventories                                         515              -          -
Due from related companies                        1,143         (2,852)      (368)

Increase (Decrease) in liabilities:
Accounts payable and accrued expenses             3,986         15,976      2,061
Deferred income                                   3,249         (1,900)      (246)
Deferred liabilities                                  -           (557)       (72)
Income taxes payable                             (1,518)        (4,690)      (605)
Taxes other than income                              81           (801)      (103)
Deferred taxation                                 1,047           (283)       (37)
                                               ---------      ---------  ---------

Net cash provided by operating activities        37,982         34,513      4,453
                                               ---------      ---------  ---------

Cash flows from investing activities:
(Prepayments for construction-in-progress)
Transfer to fixed assets                           (100)        10,379      1,339
Acquisition of property, plant and              (61,529)       (37,221)    (4,803)
equipment
Sales proceeds from disposal of  property,
plant and equipment                                   3            716         92
                                               ---------      ---------  ---------

Net cash used in investing activities           (61,626)       (26,126)    (3,372)
                                               ---------      ---------  ---------

Cash flows from financing activities
Proceeds of short-term bank loans                 2,255          1,916        247
Decrease in due from a shareholder                1,612          6,082        785
Payment of dividends to a shareholders                -              -          -
Payment of dividend to minority                                                 -
shareholders                                          -              -
Proceeds from long-term bank loans               10,000          4,000        516
Repayment of long-term bank loans                (1,070)        (6,208)      (801)

Settlement of long-term loans from third              -         (6,649)      (858)
 parties
Assumption of finance lease obligations          16,174            847        109
Capital element of finance lease rental          (6,123)        (4,538)      (585)
payments
Capital contribution of the Chinese joint
venture partner into a joint venture                  -              -         -
Repayment of loans from minority
shareholders of subsidiaries                          -           (960)      (124)
                                               ---------      ---------  ---------

Net cash provided by (used in) financing         22,848         (5,510)      (711)
activities
                                               ---------      ---------  ---------

Net increase (decrease) in cash and cash           (796)         2,877        370
equivalents

Cash and cash equivalents, at beginning of        2,509          1,954        252
    year

Cumulative translation adjustments                   39            (13)        (1)
                                               ---------      ---------  ---------

Cash and cash equivalents, at end of year         1,752          4,818        621
                                               =========      =========  =========
</TABLE>

Translation of amounts from Hong Kong Dollars ("HK$") into United States Dollars
("US$") for the convenience of the reader has been made at the exchange rate
quoted by the Asian Wall Street Journal on March 31, 1998 of US$1.00 = HK$7.75.
No representation is made that the Hong Kong Dollar amounts could have been, or
could be, converted into United States Dollars, at that rate on March 31, 1998
or at any other certain rate.

                                        3
<PAGE>


               PHYSICAL SPA $ FITNESS, INC., INC. AND SUBSIDIARIES
                   ------------------------------------------
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   ------------------------------------------
                                   (UNAUDITED)
                                   ----------


1.   ORGANIZATION AND PRINCIPAL ACTIVITIES
------------------------------------------

Physical Spa & Fitness Inc. ("the Company") was incorporated on September 21,
1988 under the laws of the United States of America under the name of Foreclosed
Realty Exchange Inc. The Company was incorporated with a share capital of 100
million common shares with par value of US$0.001 each. 7.5 million common shares
were issued and outstanding as of December 31, 1997 (10 million shares as of
June, 1998). The Company is a U.S. public company listed on the National
Association of Securities Dealers Bulletin Board.

Physical Beauty & Fitness Holdings Limited ("Physical Holdings") was
incorporated (in March 8, 1996 under the laws of the British Virgin Islands
("BVI") with a capital of one common share being held by a shareholder ("the
Shareholder"), Physical Holdings has interests in various companies ("Operating
Subsidiaries") operating fitness and beauty centers ("Fitness Centres") and
other related businesses Hong Kong and the People's Republic of China ("the
PRC").

Pursuant to a Share Exchange Agreement entered into between the Company and
Physical Holdings on August 8, 1996, the Shareholder transferred his controlling
interest, in the outstanding stock, of Physical Holdings in exchange for 80% of
the outstanding stock of the Company. The transaction was completed on October
21, 1996 when the Company became the ultimate holding company of Physical
Holdings and the Operating Subsidiaries. As part of the above transaction,
certain shareholders of the Company also transferred 990,000 pre-split (742,500
post-split) common shares to Goodchild Investments Limited ("Goodchild").
Accordingly, the Shareholder and Goodchild became the major shareholders of the
Company. In February, 1998, Goodchild sold all of its shares of common stock of
the Company.

On November 27, 1996, the Company changed its name to Physical Spa & Fitness,
Inc.

The Shareholder's interests in the fitness and beauty centers in Hong Kong and
the PRC and other related businesses were originally conducted through Physical
Health Centre Hong Kong Limited ("Physical HK"), a Hong Kong, corporation
established on March 2, 1990 by two principal shareholders ("the Principal
Shareholders"), one of which is the Shareholder. In 1994, the share capital was
increased and additional shares were issued to the Principal Shareholders as
well as other shareholders.

Physical HK was established to succeed to and continue the operation of two
Fitness Centres and other related businesses previously operated by the
Principal Shareholders in Hong Kong in the form of a sole proprietorship.

                                        4


<PAGE>


1.   ORGANIZATION AND PRINCIPAL ACTIVITIES (Cont'd)
---------------------------------------------------

During the period from 1990 to 1996, Physical HK and Physical Holdings expanded
their scope of operations by acquiring and establishing, several subsidiary,
companies and by forming Sino-foreign joint ventures in the PRC to operate six
additional Fitness Centres in Hong Kong, two in Shanghai and one in Dalian, the
PRC and other related businesses. These subsidiary companies were all formerly
jointly owned by the Principal Shareholders or solely by the Shareholder. The
respective equity interests were transferred by the Principal Shareholders to
Physical HK or Physical Holdings throughout 1993 to 1996 at the original cost of
the respective investments.

On October 19, 1996, 91.4% of the equity interests of Physical HK was
transferred by the Principal Shareholders and other shareholders of Physical HK
to Physical Holdings at the par value of the shares transferred. In addition,
all the equity interests of Physical HK in various subsidiaries and a
Sino-foreign joint venture were also transferred to Physical Holdings at the
recorded cost of these investments. The Company, Physical Holdings and the
Operating Subsidiaries are collectively known as the Group. They are all
distinct legal entities with limited liability.

The transfer of the Shareholder's interests in Physical Holdings and the
Operating Subsidiaries was a reorganization of companies under common control
and has been accounted for effectively as a pooling of interests and the
consolidated financial statements of the Company have been presented as if the
Operating Subsidiaries had been owned by the Company since their date of
incorporation or acquisition by the Shareholder whichever is later.

                                        5

<PAGE>


1.   ORGANIZATION AND PRINCIPAL ACTIVITIES (Cont'd)
---------------------------------------------------
<TABLE>

The details of Physical Holdings and Operating Subsidiaries and their principal
activities as of the date of this report are summarized below:
<CAPTION>

                                              Date of                               Equity interest
                                              acquisition/          Place of        owned by the
Name of Company                               formation             incorporation   Company              Principal activities
---------------                               ---------             -------------   -------              --------------------
                                                                                    Direct  Indirect
                                                                                    ------  --------
<S>                                           <C>                   <C>             <C>      <C>         <C>
Physical Beauty & Fitness Holdings            March 8, 1996         BVI             100%       -         Investment holding
   Limited ("Physical Holdings:)

Physical Health Centre Hong Kong              March 2, 1990         Hong Kong        91.4%     -         Operating 5 Fitness Centres
   Limited ("Physical HK")                                                                                 in Hong Kong

Regent Town Holdings Limited                  September 20,         BVI              88.5%     -         Investment holding
   ("Regent")                                 1993

Supreme Resources Limited ("Supreme")         September 29,         Hong Kong        70%       -         Operating a beauty
                                              1994                                                         treatment centre in Hong
                                                                                                           Kong

Physical Health Centre (Zhong Shan)           September 29,         Hong Kong        100%      -         Investment holding
   Limited ("Zhongshan Physical")             1994                                                        (formerly operating a
   (formerly known as Famerich                                                                             beauty treatment centre
   Development Limited ("Famerich")                                                                        in Hong Kong)

Zhongshan Physical Ladies' Club Ltd.          October 29, 1996      The PRC            -      95%        Operating a Fitness Centre
   (Owned by Zhongshan Physical)                                                                           in Zhongshan, the PRC

Ever Growth limited ("Ever Growth")           September 29,         Hong Kong        100%      -         Property holding
                                              1994

Proline Holdings Limited ("Proline")          September 28,         BVI                -      88.5%      Investment holding
   (wholly owned by Regent)                   1994

Shanghai Physical Ladies' Club Company        September 28,         Hong Kong          -      88.5%      Investment holding
   Limited ("Shanghai Physical")              1994
   (wholly owned by Proline)

Shanghai Physical Ladies' Club Co., Ltd.      September 28,         The PRC            -      88.5%      Operating two Fitness
   (owned by Shanghai Physical)               1994                                                         Centres in Shanghai, the
                                                                                                           PRC

Mighty System Limited ("Mighty")              December 15,          BVI              100%      -         Provision of marketing
                                              1994                                                         services for cosmetics
                                                                                                           sales
Jade Regal Holdings Limited ("Jade            March 15, 1996        BVI              100%      -         Investment holding
   Regal")

Physical Health Centre (Dalian) Limited       March 15, 1996        Hong Kong          -     100%        Investment holding
   ("Dalian  Physical") (wholly owned by
   Jade Regal)

Dalian Physical Ladies' Club Co., Ltd.        March 15, 1996        The PRC            -      90%        Operating a Fitness Centre
   (90% owned by Dalian Physical)                                                                          in Dalian, the PRC

Star Perfection Holdings Limited ("Star       April 15, 1996        BVI              100%      -         Investment holding
   Perfection")

Physical Health Centre (Shenzhen)             April 15, 1996        Hong Kong          -     100%        Investment holding
   Limited ("Shenzhen Physical")
   (wholly owned by Star Perfection)

Shenzhen Physical Ladies' Club Co., Ltd.      August 16, 1996       The PRC            -      90%        Operating a Fitness Centre
    (owned by "Shenzhen Physical")                                                                         in Shenzhen, the PRC

Physical Health Centre (Macau) Limited        March 21, 1997        Hong Kong        100%      -         Investment holding
    ("Macau Physical")

Physical Health Centre (Tsuen Wan) Limited    September 8, 1997     Hong Kong        100%      -         Operating a Fitness Centre
    ("Tsuen Wan Physical")                                                                                 in Hong Kong

</TABLE>

                                        6

<PAGE>

1.   ORGANIZATION AND PRINCIPAL ACTIVITIES (Cont'd)
---------------------------------------------------

Regent Town Holdings Limited ("Regent") was originally 67% owned by Physical HK
upon its incorporation. In June, 1995, Physical HK increased its equity interest
to 83.5% by acquiring additional shares issued by Regent at the par value of the
shares. In June, 1996, 5% of the equity interests of Regent owned by a minority
shareholder was acquired by the Shareholder (see Note 6(d)). All the shares
owned by Physical HK and the Shareholder were then transferred to Physical
Holdings at the original cost of investments to the Physical HK and the
Shareholder.

Famerich was incorporated to operate a beauty treatment centre in Hong Kong. The
business was closed down in late 1994 and the company became dormant thereafter.
The loss of HK$1,332 resulting from the shut down has been included in the
consolidated statement of income for the three-month period from October 1 to
December 31, 1994. In June, 1996, Famerich changed its name to Zhongshan
Physical and it then entered into a joint venture contract to establish a
Sino-foreign co-operative joint venture for the provision of physical fitness
and beauty treatment services through a Fitness Centre in the PRC. (see details
below)

The Group operates Fitness Centres in the PRC through some of its Operating,
Subsidiaries which are Sino-foreign joint ventures established in the PRC.
Detailed information in connection with these joint ventures is as follows:

<TABLE>
<CAPTION>

                                              INTERESTS      TERM OF
NAME OF THE                        TYPE OF     OWNED BY        THE
JOINT VENTURE                       JOINT        THE          JOINT     REGISTERED
                      LOCATION     VENTURE      GROUP        VENTURE      CAPITAL          PROFIT SHARING ARRANGEMENT
                                                                                           FOREIGN  CHINESE
                                                                                           PARTNER  PARTNER
<S>                   <C>          <C>          <C>          <C>          <C>              <C>
Shanghai              Huangpu      Co-          88.5%        10 years     Originally       See arrangement of p.13
Physical Ladies'      and          operating                              US$1,000 in
Club Co., ltd.        Hongqiao,                                           cash and
("Shanghai JV")       Shanghai                                            increased
                                                                          to US$2,000
                                                                          in cash in 1995

Dalian Physical       Dalian       Equity       originally   12 years     Originally       Pro-rata to equity
Ladies' Club                                    at 55%                    Rmb10,000        interests
Co., Ltd.                                       and                       in cash and
("Dalian JV")                                   changed                   changed to
                                                to 90% in                 Rmb1,000
                                                1996                      in cash and
                                                                          Rmb9,000
                                                                          in form of
                                                                          fixed assets
                                                                          and
                                                                          renovation
                                                                          materials in
                                                                          1996

Shenzhen              Shenzhen     Co-          90%          10 years     HK$4,600         Pro-rata to equity interests
Physical                           operative                              in form of
Ladies' Club                                                              cash and
Co. Ltd.                                                                  fixed assets
("Shenzhen
JV")

Zhongshan             Zhongshan    Equity       95%          10 years     US$500 in        Pro-rata to equity interests
Physical Ladies                                                           form of
Club Co. Ltd.                                                             cash and
("Zhongshan                                                               fixed assets
JV")

</TABLE>
                                       7

<PAGE>


1.   ORGANIZATION AND PRINCIPAL ACTIVITIES (Cont'd)
---------------------------------------------------

Other special provisions of these joint ventures are summarized as follows:

Shanghai JV
-----------

Pursuant to an agreement between Physical HK and Shanghai Physical dated July
20, 1993, Shanghai Physical authorized Physical HK to enter into a joint venture
contract ("the Contract") on its behalf with the Chinese joint venture partner.
Under this agreement, benefits, rights and obligations arising from the Contract
belong to Shanghai Physical. Physical HK contributed the required capital on
behalf of Shanghai Physical.

According to the provisions of the Contract, Shanghai Physical contributed 100%
of the registered capital of the joint venture while the Chinese joint venture
partner provided the premises in which the Fitness Centres are located. Upon
dissolution of the joint venture, all fixed assets of the joint venture will be
assumed by the Chinese joint venture partner while Shanghai Physical will assume
all the working capital, debts and outstanding obligations and commitments. For
the first three years of the joint venture, the Chinese joint venture partner
will be entitled only to rent of Rmb950 per annum. Thereafter, the rental
payment will be increased by 10% per annum unless the inflation rate in the PRC
is higher than 16%. The Chinese joint venture partner has no further entitlement
to the profits of the joint venture.

Shenzhen JV
-----------

According to the laws in the PRC and the terms of the joint venture contract,
both joint venture partners are obliged to fulfill their capital contribution
requirements into the joint venture within a specified period of time after the
issue of the business license. As of the date of this report, however, both
joint venture partners have not contributed the required capital according to
the requirements of the contract. Such default in the funding obligations will
require renegotiations between the two partners and may also trigger default
remedies as specified in the joint venture contract. Further, a failure to meet
regulatory time limits set by the State Administration of Industry and Commerce
for capital contributions could result in the cancellation of the approval of
the joint venture's business license. Both joint venture partners are in the
process of applying to the relevant authorities for an extension of such time
limits.

The joint venture has not yet commenced operations as of the date of this
report.

                                       8
<PAGE>


1.   ORGANIZATION AND PRINCIPAL ACTIVITIES (Cont'd)
---------------------------------------------------

Zhongshan JV
------------

Similar to the Shenzhen JV, both joint venture partners have not yet fulfilled
their required capital contribution bligations within the specified time limit.
The joint venture partners are in the process of applying for extension of such
time limits from the relevant authorities.

On August 2, 1996, a supplementary agreement was signed between the joint
venture partners to amend the provisions of the contract to the extent that all
the benefits and liabilities of the joint venture will be assumed by Zhongshan
Physical. In return, the Chinese joint venture partner will be entitled to HK$30
per annum in the form of a technology introduction fee. The Chinese joint
venture partner will not be entitled to share in the profits of the joint
venture after receipt of the technology introduction fee. The supplementary
agreement is subject to the approval of the relevant PRC authorities.

The joint venture has not yet commenced operations as of the date of this
report.

Since the Shanghai JV and the Dalian JV operate in the PRC, they are subject to
special considerations and significant risks not typically associated with
investments in equity securities of United States and Western European
companies. These include risks associated with, among others, the political,
economic and legal environments and foreign currency exchange. These are
described further in the following paragraphs:

POLITICAL ENVIRONMENT

The value of the Company's interests in the Shanghai and Dalian JVs may be
adversely affected by significant political, economic and social uncertainties
in the PRC. A change in policies by the Chinese government could adversely
affect the Company's interests in the Shanghai and Dalian JVs by, among other
factors: changes in laws, regulations or the interpretation thereof;
confiscatory taxation; restrictions on foreign currency conversion, imports or
sources of suppliers; or the expropriation or nationalization of private
enterprises.


                                       9
<PAGE>



1.   ORGANIZATION AND PRINCIPAL ACTIVITIES (Cont'd)
---------------------------------------------------

ECONOMIC ENVIRONMENT

The economy of the PRC differs significantly from the economies of the United
States and Western Europe in such respects as structure, level of development,
gross national product, growth rate, capital reinvestment, resource allocation,
self-sufficiency, rate of inflation and balance of payments position, among
others. Only recently has the Chinese government encouraged substantial private
economic activities.

The Chinese economy has experienced significant growth in the past five years,
but such growth has been uneven among various sectors of the economy and
geographic regions. Actions by the Chinese central government to control
inflation have significantly restrained economic expansion recently. Similar
actions by the central government of the PRC in the future could have a
significant adverse effect on economic conditions in the PRC and the economic
prospects for the Group.

FOREIGN CURRENCY EXCHANGE

The Chinese central government imposes control over its foreign currency
reserves through control over imports and through direct regulation of the
conversion of its national currency into foreign currencies. As a result, the
Renminbi is not freely convertible into foreign currencies.

The Shanghai and Dalian JVs conduct substantially all of their business in the
PRC, and their financial performance and condition are measured in terms of
Renminbi. The revenues and profits of the Shanghai and Dalian JVs are
predominantly denominated in Renminbi, and will have to be converted to pay
dividends to the Company in United States Dollars or Hong Kong Dollars. Should
the Renminbi devalue against these currencies, such devaluation would have a
material adverse effect on the Company's profits and the foreign currency
equivalent of such profits repatriated by the Shanghai and Dalian JVs to the
Company. The Company currently is not able to hedge its exchange rate exposure
in the PRC because neither the banks in the PRC nor any other financial
institution authorized to engage in foreign exchange transactions offer forward
exchange contracts.

LEGAL ENVIRONMENT

Since 1979, many laws and regulations dealing with economic matters in general
and foreign investment in particular have been enacted in the PRC. However, the
PRC still does not have a comprehensive system of laws and enforcement of
existing laws may be uncertain and sporadic.


                                       10
<PAGE>



2.   BASIS OF PRESENTATION
--------------------------

The financial year end date of Physical HK and the Operating Subsidiaries
incorporated in Hong Kong and the BVI was September 30 up to September 30, 1994
while the PRC joint ventures' financial year end is December 31. Pursuant to
members' resolutions passed by Physical HK and the Operating Subsidiaries
incorporated in Hong Kong and the BVI, their financial year end dates were all
changed to December 31 in 1995. For presentation purposes, the consolidated
financial statements of the Group for the fifteen month period from October 1,
1994 to December 31, 1995 have been segregated to report the results of
operations and cash flows for the three-month period from October 1, 1994 to
December 31, 1994 separately from those for the twelve-month period from January
1, 1995 to December 31, 1995.

Unaudited stub period consolidated income statements of the Group for the
three-month period from October 1, 1993 to December 31, 1993 are presented for
comparison purposes.

The accompanying consolidated financial statements were prepared in accordance
with generally accepted accounting principles in the United States of America
("US GAAP"). This basis of accounting differs from that used in the statutory
financial statements of the BVI and Hong Kong Operating Subsidiaries and the PRC
joint ventures, which were prepared in accordance with generally accepted
accounting principles in Hong Kong ("HK GAAP") and the accounting principles and
the relevant financial regulations applicable to enterprises with foreign
investments as established by the Ministry of Finance of China ("PRC GAAP")
respectively.


3.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
-----------------------------------------------

     a.  Basis of Consolidation
     --------------------------

     The consolidated financial statements include the financial statements of
     the Company, its majority owned and controlled subsidiaries and joint
     ventures. All material intercompany balances and transactions have been
     eliminated.

     b.  Revenue & Deferred Income
     -----------------------------

     Revenue represents membership fees and service income in connection with
     the provision of physical fitness and beauty treatment services and other
     related income, net of the related sales tax, if any. Annual membership
     fees and service income and other related income are recognized when
     services are rendered. During 1996, the Company changed its membership
     policy so that the annual membership fee was replaced by a non-refundable
     membership admission fee and monthly dues. The admission fee is recognized
     in full as revenue upon membership being granted while the monthly dues are
     recognized as revenue on a monthly basis.

     Deferred income represents membership fees and service fees billed but the
     related services, or portion of the services, have not yet been rendered.

                                       11
<PAGE>



3.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
--------------------------------------------------------

     c.  Cash and Cash Equivalents
     -----------------------------

     Cash and cash equivalents include cash on hand, demand deposits with banks
     and liquid investments with an original maturity of three months or less.


     d.  Property Plant and Equipment
     --------------------------------

     Property, plant and equipment are stated at cost less accumulated
     depreciation. Depreciation of property, plant and equipment is computed
     using the straight line method over the assets' estimated useful lives. The
     estimated useful lives are as follows:

          Leasehold land held under long-term lease          Over the lease term
          Buildings                                               20 to 50 years
          Leasehold improvements                             Over the lease term
          Machinery and equipment                                  5 to 10 years
          Furniture and fixtures                                         5 years
          Computers                                                 4 to 5 years
          Motor vehicles                                            4 to 5 years

     e.  Taxation: Income Taxes
     --------------------------

     No provision for withholding or U.S. federal income taxes or tax benefits
     on the undistributed earnings and/or losses of the Operating Subsidiaries
     has been provided as the earnings of the Operating Subsidiaries, in the
     opinion of the management, will be reinvested indefinitely.

     Physical HK, Supreme, Zhongshan Physical, Ever Growth, Shanghai Physical,
     Dalian Physical and Shenzhen Physical, Macau Physical and Tsuen Wan
     Physical were incorporated under the laws of Hong Kong. They provide for
     Hong Kong profits tax at a rate of 16.5% on the basis of their income for
     financial reporting purposes, adjusted for income and expense items which
     are not assessable or deductible for income tax purposes.

     Physical Holdings, Regent, Mighty, Proline, Jade Regal and Star Perfection
     were incorporated under the laws of BVI and under these laws, they are not
     subject to tax on income or on capital gains.

     The Shanghai and Dalian JVs, which were incorporated under the laws of the
     PRC, provide for enterprise income tax on their assessable income in
     accordance with the relevant regulations of the PRC, after considering all
     available tax benefits and allowances. They are subject to Chinese
     enterprise income taxes at he applicable tax rate of 33%.


                                       12
<PAGE>

3.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
--------------------------------------------------------

     e.  Taxation: Income Taxes
     --------------------------

     The Group provides for deferred income taxes using the liability method, by
     which deferred income taxes are recognized for all significant temporary
     differences between the tax and financial statement bases of assets and
     liabilities. The tax consequences of those differences are classified as
     current or non-current based upon the classification of the related assets
     or liabilities in the financial statements. A valuation allowance is
     provided for the portion of deferred tax assets that is not currently
     realizable, since the realization of these benefits depends upon the
     ability of the relevant entity to generate income in future years.

     f.  Taxation: Sales Taxes
     -------------------------

     According to the tax regulations promulgated by the PRC government which
     came into effect on January 1, 1994, the Shanghai and Dalian JVs are
     subject to Business Tax ("BT") calculated at 5% on the gross service income
     received by the joint venture.

     BT is recognized on the accrual basis. Sales revenue is recorded in the
     financial statements net of BT.


     g.  Foreign Currency Translation
     --------------------------------

     The Company, Physical Holdings and the Hong Kong and BVI Operating
     Subsidiaries maintain their accounting books and records in Hong Kong
     dollars ("HK$"). Foreign currency transactions during the year are
     translated into HK$ at rates of exchange prevailing at the time of the
     transactions. Monetary assets and liabilities denominated in foreign
     currencies at year end are translated at the rates of exchange prevailing
     at the balance sheet date. Non-monetary assets and liabilities are
     translated at the rates of exchange prevailing at the time the asset or
     liability was acquired, Exchange gains or losses are recorded in the
     consolidated statements of income.

     The PRC Operating Subsidiaries maintain their books and records in
     Renminbi. Foreign currency transactions are translated into Renminbi at the
     applicable exchange rate quoted by the People's Bank of China ("the unified
     exchange rate"), prevailing at the dates of the transactions. Monetary
     assets and liabilities denominated in foreign currencies are translated
     into Renminbi using the applicable unified exchange rates at the balance
     sheet date. The resulting exchange differences are included in the
     determination of income.


                                       13
<PAGE>


3.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
--------------------------------------------------------

     g.  Foreign Currency Translation (Cont'd)
     -----------------------------------------

     Renminbi is not freely convertible into foreign currencies. All foreign
     exchange transactions involving Renminbi must take place either through the
     Bank of China or other institutions authorized to buy and sell foreign
     currencies, or at a swap centre. Before January 1, 1994, the exchange rates
     used for transactions through the Bank of China and other authorized
     institutions were set by the government (the "official exchange rate") from
     time to time whereas the exchange rates available at the swap centres (the
     "swap centre rates") were determined largely by supply and demand. The
     Chinese government announced the unification of the two-tier exchange rate
     systems in December 1993 effective January 1, 1994. The unification brought
     the official exchange rate of the Renminbi in line with the swap centre
     rate. The unification did not have a major impact on the consolidated
     financial statements of the Company under US GAAP.

     On consolidation, the financial statements of the PRC Operating
     Subsidiaries are translated into Hong Kong Dollars using the closing rate
     method, whereby the balance sheet items are translated into Hong Kong
     Dollars using the unified exchange rates at the respective balance sheet
     dates. The share capital and retained earnings are translated at historical
     unified exchange rates prevailing at the time of the transactions while
     income and expense items are translated at the average unified exchange
     rates for the years/period. The resultant translation differences are
     recorded in the consolidated balance sheets as cumulative translation
     adjustments which are included as a separate account in shareholders'
     equity in the accompanying balance sheets.

     h.  Finance Leases
     ------------------

     Leases that substantially transfer to the Group all the rewards and risks
     of ownership of assets, other than legal title, are accounted for as
     finance leases.

     Fixed assets held under finance leases are initially recorded at the
     present value of the minimum lease payments at the inception of the leases,
     with equivalent liabilities categorized as appropriate under current or
     non-current liabilities.

     Finance charges, which represent the difference between the minimum lease
     payments at the inception of the leases and the fair value of the assets
     acquired, are allocated to accounting periods over the period of the
     relevant leases so as to produce a constant periodic rate of charge on the
     outstanding balances.

                                       14
<PAGE>



3.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
--------------------------------------------------------


     i.  Operating Leases
     --------------------

     Leases where substantially all the rewards and risks of ownership of assets
     remain with the lessors are accounted for as operating leases. Rental
     payments under operating leases are expensed as incurred.

     j.  Related Companies
     ---------------------

     A related company is a company in which one or more of the directors or
     shareholders of the Company have direct or indirect beneficial interests.

4.   SHORT-TERM BANK LOANS
--------------------------

The short-term bank loans are secured and repayable within one year.

5.   LONG-TERM BANK LOANS
-------------------------

Long-term bank loans bear interest at 11% on the outstanding balances. As of
December 31, 1996 and September 30, 1997, the Group had various banking
facilities available from financial institutions. These facilities were secured
by:

     i.   leasehold property in Hong Kong owned by Evergrowth;
     ii.  leasehold property in Hong Kong owned by relatives of the Principal
          Shareholders;
     iii. leasehold property in Hong Kong owned by a related
          company;
     iv.  personal guarantees from the Principal Shareholders and their
          relatives;
     v.   joint and several guarantees for HK$5,248 from the Principal
          Shareholders; and
     vi.  foreign currency fixed deposit of AUD47 from relatives of the
          Principal Shareholders.


                                       15
<PAGE>

6.   PROVISION FOR INCOME TAXES
-------------------------------

Hong Kong profits tax was provided at 16.5% on the assessable profits of
Physical HK.

Enterprise income tax was provided at 33% on the assessable income of the
Shanghai and Dalian JVs in accordance with the relevant tax regulations of the
PRC.

The other BVI and Hong Kong Operating Subsidiaries, except Physical HK, did not
provide for any income taxes during the period/years as they did not have any
assessable income.

The combined tax provision in each period was currently payable, except for the
year ended December 31, 1996 and September 30, 1997, when HK$6,946 and HK$3,722
of the provisions were currently payable and HK$1,753 and HK$1,047 were
deferred.

7.  OBLIGATIONS AND COMMITMENTS
--------------------------------

a.   Physical HK leases fitness equipment and motor vehicles under several
     finance leases with lease terms extending from 1994 to 1999.

b.   Long-term loans payable and Share options to lenders
     -------------------------------------------------------

     Pursuant to five separate loan agreements entered into between Physical HK
     and five third party lenders ("the Lenders") in 1995 and 1996, Physical HK
     borrowed a sum of approximately US$1,800 (HK$13,916) ("the Loans") from the
     Lenders. The Loans will be fully repayable in 1998, twenty-four months
     after the drawdown dates ("the Loan Periods"). The Loans bear interest at
     three percent over the prevailing prime rate after the first eighteen
     months from the respective drawdown dates ("the Interest-free Period"). The
     effect of the Interest-free Period was not material to net income.

     According to the provisions of the same loan agreements, the Lenders were
     granted share purchase options ("the Options") to purchase 0.2% to 2.4% of
     the outstanding capital of Physical HK from the Shareholder at a value of
     HK$l per share during the Loan Periods. The Lenders also agreed to assign
     the Loans owed to them by Physical HK to the Shareholder at a value of HK$l
     per share once the options are exercised. There are also provisions in the
     agreements that the Lenders can sell the shares to the public or back to
     the Shareholder if the Group obtains a flotation during the Loan Periods.
     Up to the date of this report, the Lenders have not exercised any of the
     Options.


     Subsequent to September 30, 1997, Physical HK repaid the loan of US$540
     (HK$4,174) to two of the five third party lenders. In addition,
     supplemental loan agreements ("Supplemental Agreements") were signed
     between Physical Hong Kong and another two of the remaining three third
     party lenders in November 1997. According to the Supplemental Agreements,
     the Lender agreed to extend the Loan Periods and abandoned their rights of
     above mentioned share purchase options. In return, Physical HK will pay the
     interest at three percent over the prevailing prime rate during the
     extended loan period and a lump sum amount of US$60.

                                       16
<PAGE>


8.  RETIREMENT PLANS
---------------------

As stipulated by the regulations of the Chinese government, all of the Chinese
staff of the Shanghai and Dalian JVs are entitled to an annual pension on
retirement, which is equal to their basic salaries at their retirement dates.
The Chinese government is responsible for the pension liability to these retired
staff. The Shanghai and Dalian JVs are only required to make specified
contributions to the state-sponsored retirement plan calculated at 30% of the
basic salary of the staff.

9.  DEDICATED CAPITAL
----------------------

In accordance with the relevant laws and regulations for Sino-foreign joint
venture enterprises, the Shanghai and Dalian JVs maintain discretionary
dedicated capital, which includes a general reserve fund, an enterprise
expansion fund and a staff welfare and incentive bonus fund. The Board of
Directors of the Shanghai and Dalian JVS will determine on an annual basis the
amount of the annual appropriations to dedicated capital. Since their inception,
the Shanghai and Dalian JVs have not made any such appropriations as they
incurred losses during these periods.

10.  DISTRIBUTION OF PROFIT
---------------------------

Dividends from the Shanghai and Dalian JVs will be declared based on the profits
as reported in the statutory financial statements. Such profits will be
different from the amounts reported under US GAAP. Up to September 30, 1997, no
distribution had been made by the Shanghai and Dalian JVs as they incurred
losses during these periods.

Physical HK proposed and paid dividends of HK$32,800 for the year ended December
31, 1995 on the outstanding Common Stock. As mentioned in 6(a) and (e),
dividends payable to the Shareholder in the amount of HK$29,979 were utilized to
offset the balances owed by him to the Group. Dividends payable to the minority
shareholders of Physical HK in the amount of HKS2,821 were assigned to the
Shareholder without any consideration. They were utilized to offset the advances
made by the Group to him as noted in Note 6(a).

In the opinion of management, any undistributed earnings and/or losses of
Physical Holdings and the Operating Subsidiaries will be reinvested
indefinitely.

11.  STOCK OPTION PLAN
----------------------

The Company has a Stock Option Plan ("the Plan") which was adopted by the
Company's stockholders and its Board of Directors on April 23, 1997. Under the
Plan, the Company may issue incentive stock options, non-qualified options,
restricted stock grants, and stock appreciation rights to selected directors,
officers, advisors and employees of the Company. A total of 375,000 shares of
Common Stock of the Company are reserved for issuance under the Plan, Stock
options ("the Options") may be granted as non-qualified or incentive options.
Incentive stock options may not be granted at a price less than the fair market
value of the stock as of the date of grant while nonqualified stock options may
not be granted at a price less than 85% of the fair market value of the stock as
of the date of grant. The Plan will be administered by an Option Committee ("the
Committee") which is to be composed of two or more disinterested directors of
the Board of Directors. The Option can be exercised during a period of time
fixed by the Committee except that no option may be exercised more than ten
years after the date of grant or three years after death or disability,
whichever is later. As of the date of this report, no stock options have been
granted by the Company.


                                       17
<PAGE>


ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS


              PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

ALL FORWARD-LOOKING STATEMENTS CONTAINED HEREIN ARE DEEMED BY THE COMPANY TO BE
COVERED BY AND TO QUALIFY FOR THE SAFE HARBOR PROTECTION PROVIDED BY THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995 THE 1995 ACT SHAREHOLDERS AND
PROSPECTIVE SHAREHOLDERS SHOULD UNDERSTAND THAT SEVERAL FACTORS GOVERN WHETHER
ANY FORWARD - LOOKING STATEMENT CONTAINED HEREIN WILL BE OR CAN BE ACHIEVED. ANY
ONE OF THOSE FACTORS COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE
PROJECTED HEREIN. THESE FORWARD - LOOKING STATEMENTS INCLUDE PLANS AND
OBJECTIVES OF MANAGEMENT FOR FUTURE OPERATIONS, INCLUDING PLANS AND OBJECTIVES
RELATING TO THE PRODUCTS AND THE FUTURE ECONOMIC PERFORMANCE OF THE COMPANY.
ASSUMPTIONS RELATING TO THE FOREGOING INVOLVE JUDGMENTS WITH RESPECT TO, AMONG
OTHER THINGS, FUTURE ECONOMIC, COMPETITIVE AND MARKET CONDITIONS, FUTURE
BUSINESS DECISIONS, AND THE TIME AND MONEY REQUIRED TO SUCCESSFULLY COMPLETE
DEVELOPMENT PROJECTS, ALL OF WHICH ARE DIFFICULT OR IMPOSSIBLE TO PREDICT
ACCURATELY AND MANY OF WHICH ARE BEYOND THE CONTROL OF THE COMPANY. ALTHOUGH THE
COMPANY BELIEVES THAT THE ASSUMPTIONS UNDERLYING THE FORWARD - LOOKING
STATEMENTS CONTAINED HEREIN ARE REASONABLE, ANY OF THOSE ASSUMPTIONS COULD PROVE
INACCURATE AND, THEREFORE, THERE CAN BE NO ASSURANCE THAT THE RESULTS
CONTEMPLATED IN ANY OF THE FORWARD - LOOKING STATEMENTS CONTAINED HEREIN WILL BE
REALIZED. BASED ON ACTUAL EXPERIENCE AND BUSINESS DEVELOPMENT, THE COMPANY MAY
ALTER ITS MARKETING, CAPITAL EXPENDITURE PLANS OR OTHER BUDGETS, WHICH MAY IN
TURN AFFECT THE COMPANY'S RESULTS OF OPERATIONS. IN LIGHT OF THE SIGNIFICANT
UNCERTAINTIES INHERENT IN THE FORWARD - LOOKING STATEMENTS INCLUDED THEREIN, THE
INCLUSION OF ANY SUCH STATEMENT SHOULD NOT BE REGARDED AS A REPRESENTATION BY
THE COMPANY OR ANY OTHER PERSON THAT THE OBJECTIVES OR PLANS OF THE COMPANY WILL
BE ACHIEVED.


Overview of Company's Business:

         The Company, through its predecessor companies and its subsidiaries,
has been an established commercial operator of fitness and spa centers in Hong
Kong and China since 1986 (see "Company - History"). As of September 30, 1998,
the Company operated ten facilities: seven in Hong Kong and three in China.
Management believes that the Company is one of the top providers of fitness
facilities and spa and beauty treatment services in Hong Kong and China, with
approximately 55,000 members. The Company offers to its customers, at each
location, access to a wide range of U.S.- styled fitness and spa services.

          The Company was incorporated on September 21, 1988 in the state of
Delaware under the name of "Foreclosed Realty Exchange, Inc", a development
stage company seeking acquisitions with no material assets or liabilities. Prior
to acquisition of Physical Beauty & Fitness Holdings Limited, a British Virgin
Islands corporation ("Physical Limited"), the Company had no revenue producing
operations, but planned to enter into joint ventures and/or acquisitions
originally in the area of real estate, to expand its operations. In October,
1996, the Company closed a transaction with Ngai Keung Luk (Serleo), a 100%
shareholder of Physical Limited, whereby the Company entered into a Share
Exchange Agreement with Ngai Keung Luk (Serleo), pursuant to which the Company
issued 8,000,000 pre-split (6,000,000 post-split) shares of its Common Stock to
Ngai Keung Luk (Serleo) in exchange for all of the outstanding shares of
Physical Limited (the "Closing"). At the Closing, the then current management of
the Company resigned and was replaced by the current management of the Company.

                                       18
<PAGE>

RESULTS OF OPERATIONS

        The Company's revenues are derived from its two main lines of business
of fitness and spa services in three principal ways: sale of memberships to
fitness facilities, monthly membership fees and the sale of beauty treatments .
The sale of beauty products and exercise clothing also contributes an
insignificant amount to the total revenues. In respect to fitness services,
customers are invited to join as a member at a fee currently set at
HK$1,500(US$194) for one person. (A current promotion allows two people for
joining fee of HK$1,000 (US$129) each). A monthly subscription fee of HK$299
(US$39) is charged to each customer for the usage of the fitness center and spa
area.

        In respect to beauty treatments, the customers may purchase single
treatments, or in packages of ten or more treatments, with quantity discounts
available. There is a wide range of beauty treatments available at prices
ranging from HK$200 (US$26) to HK$3,000 (US$388).

        The following table sets forth selected income data as a percentage of
total operating revenue for the periods indicated.

<TABLE>

RESULTS OF OPERATIONS
<CAPTION>
                                                             Years Ended              Nine Months Ended
                                                             December 31,               September 30,
                                                    ------------------------------   -------------------
                                                      1995       1996       1997       1997       1998
                                                    --------   --------   --------   --------   --------
<S>                                                 <C>         <C>        <C>        <C>        <C>
Operating Revenues                                   100.00%    100.00%    100.00%    100.00%    100.00%
Total operating expenses                              71.34%     71.52%     80.37%     78.56%     90.41%
Operating income                                      28.66%     28.48%     19.62%     21.44%      9.59%
Income before income taxes and minority interests     28.23%     28.52%     18.31%     20.68%      7.97%
Provision for income and deferred taxes                5.20%      7.55%      4.68%      4.49%     (1.03%)
Minority interests                                     2.46%      1.99%      1.23%      1.59%      0.65%
Net income                                            20.56%     18.98%     12.40%     14.60%      8.35%
                                                    ========   ========   ========   ========   ========
</TABLE>


NINE MONTHS ENDED SEPTEMBER 30, 1998 (UNAUDITED) COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 1997 (UNAUDITED).
--------------------------------------------------------------------------------

        OPERATING REVENUES. The Company's operating revenues enjoyed strong
growth in the first nine months of 1998 as compared to the first nine months of
1997. Operating revenues for the first nine months of 1998 totaled
HK$148,242,000 (US$19,129,000) compared to HK$106,133,000 (US$13,695,000) in the
first nine months of 1997, representing an increase of 40%. Operating revenues
derived by the Company's fitness services increased 76% to HK$96,856,000
(US$12,498,000) compared to HK$55,161,000 (US$7,118,000) in the first nine
months of 1997. Fitness revenues as a percentage of total revenues were 65% in
the first nine months of 1998 as compared to 52% in the first nine months of
1997.

                                       19
<PAGE>

        Operating revenues from the Company's beauty treatment business totaled
HK$51,334,000 (US$6,624,000) compared to HK$50,862,000 (US$6,563,000) in the
first nine months of 1997, representing a negligible increase of 1%. This was
mainly due to the Company's focus on the fitness business during that period of
time, which resulted from the opening of the largest center in Mid-1998. The
Company also advertised the new center, which drew more attention to the fitness
business. Beauty treatment revenues as a percentage of total revenues were 35%
in the first nine months of 1998 as compared to 48% in the first nine months of
1997.

        OPERATING EXPENSES. The Company's operating expenses for the first nine
months of 1998 totaled HK$134,030,000 (US$17,295,000) compared to HK$83,376,000
(US$10,758,000) in the first nine months of 1997, representing an increase of
61%. Total operating expenses, after taking into account all corporate expenses,
were 90% of total operating revenue, as compared to 79% of last year. This
reflects the additional costs incurred by the Company in following its business
expansion plan. The increase in operating expenses was primarily due to
additional marketing, administrative and salary costs as a result of increased
revenues and additional costs incurred by the new branch as well as the two
branches which were relocated to the new premises in the middle of 1997.

        TOTAL NON-OPERATING EXPENSES. Total non-operating expenses for the first
nine months of 1998 were HK$2,393,000 (US$309,000) compared to HK$807,000
(US$104,000) in the first nine months of 1997.

        PROVISION FOR INCOME TAXES. Provision for income taxes for the first
nine months of 1998 included an adjustment for the over-provision of taxation in
previous years and therefore resulted in a negative provision of HK$1,524,000
(US$197,000) compared to a provision of HK$4,769,000 (US$615,000) in the first
nine months of 1997.

        NET INCOME. The Company's net income for the first nine months of 1998
totaled HK$12,383,000 (US$1,598,000) compared to HK$15,492,000 (US$1,999,000)
for the first nine months of 1997, representing a decrease of 20%. The net
income margin in the first nine months of 1998 was 8.4% compared to 14.6% in the
first nine months of 1997, representing a decrease of 42%. The decreased net
income reflects increased marketing expenses of the Company.

LIQUIDITY AND CAPITAL RESOURCES

        The Company has financed its operations primarily through cash generated
from operations, short-term bank credit, long-term bank loans, loans from third
parties (outside investors ) and minority shareholders of subsidiaries, advances
from customers relating to prepaid fitness and spa income, and leasing
arrangements with financial institutions. See Notes to Financial Statements
(Note 6 "Related Party Transactions"; Note 7 "Short Term Bank Loans"; Note 8
"Long Term Bank Loans"; and Note 10(c) "Obligations and Commitments").

        Cash and cash equivalent balances for the respective periods ended
September 30, 1998 and December 31, 1997 were HK$4,817,000 (US$622,000) and
HK$1,954,000 (US$252,000), while total indebtedness at September 30, 1998 was
HK$36,116,000 (US$4,660,000) and HK$46,382,000 (US$5,985,000) at December 31,
1997.

        Net cash provided by operating activities were HK$37,982,000
(US$4,901,000) and HK$34,513,000 (US$4,453,000) for Fiscal Year 1997, and the
nine-month period ended September 30, 1998, respectively. The Company's
operating activities are historically financed by cash flows from operations.
Net cash used in investing activities were HK$61,626,000 (US$7,952,000)and
HK$26,126,000 (US$3,372,000) for Fiscal Year 1997 and the nine-month period
ended September 30, 1998, primarily as a result of expenditures for property,
plant and equipment. Net cash provided by financing activities was HK$22,848,000
(US$2,948,000) for Fiscal Year 1997 whilst net cash used in financing activites
was HK$5,510,000 (US$711,000) for the nine-month period ended September 30, 1998
mainly due to repayment of loans.


                                       20
<PAGE>

        The Company obtained a term loan in the amount of HK$1,000,000
(US$129,000) at an interest rate of 10.5% per annum from Shanghai Commercial
Bank Limited in Fiscal Year 1996 in connection with payment of rental deposits
for the new Causeway Bay center (relocation of an existing center). This loan is
secured by leasehold property in Hong Kong owned by relatives of Mr. Luk and is
repayable in one lump sum on November 6, 1997. No consideration has been paid by
the Company for such security. As of September 30, 1998, the outstanding
principal amount of this loan was HK$1,000,000 (US$129,000). The Company has
negotiated with the bank to replace the loan with a new loan which is to be
repaid by sixty (60) equal monthly installment payments commencing November,
1997.

        The Company entered into a capital lease agreement with East Asia
Finance Company Limited in April, 1996 for the purchase of exercise equipment in
the amount of HK$1,759,200 (US$227,000) for the Dalian, China, center . The
lease is repayable in thirty six (36) monthly installments, commencing April,
1996 at an interest rate of 6.75% per annum. In addition, the Company secured a
loan of HK$3,168,000 (US$409,000) from Dao Heng Finance in August 1996 for the
equipment for a proposed new center in Zhongshan, China, however, the loan was
fully repaid in February 1997. In March, 1997 the Company entered into a capital
lease agreement with the Hongkong and Shanghai Banking Corporation Limited for
the purchase of exercise equipment in the amount of HK$7,432,320 (US$959,000)
for the centers in Hong Kong. The lease is repayable in sixty (60) monthly
installments, commencing April, 1997 at an interest rate of 10.75% per annum. In
May, 1997 the Company entered into a capital lease agreement with East Asia
Finance Company, Limited for the purchase of exercise equipment in the amount of
HK$7,742,000 (US$999,000) for the Hong Kong centers. The lease is repayable in
thirty (30) monthly installments, commencing May, 1997 at an interest rate of
6.5% per annum.

        The Company has revolving lines of credit with four banks - The
Kwangtung Provincial Bank (at an interest rate of 10.75%), Dao Heng Bank (at an
interest rate of 10.75%), Shanghai Commercial Bank Limited (at interest rates of
11.5% and 12.25%) and Hongkong and Shanghai Banking Corporation Limited (at an
interest rate of 11%). As of September 30, 1998, the Company fully utilized
these revolving lines of credit. The Company draws down from the lines of credit
primarily for general working capital purposes. The lines of credit contain
covenants requiring the maintenance of minimum net worth.

        Consistent with the general practice of the fitness and spa industry,
the Company receives prepaid memberships to fitness facilities, which are
non-refundable, and spa treatment dues from its customers. This practice creates
working capital that the Company generally utilizes for working capital
purposes. However, the unused portion of the pre-paid membership and spa
treatment dues is characterized as deferred income, a current liability, for
accounting purposes.

        The Company's trade receivable balance at September 30, 1998, was
HK$7,682,000 (US$991,000). The Company has never experienced any significant
problems with collection of accounts receivable from its customers.

         Capital expenditure for Fiscal Year 1997 and the nine-month period
ended September 30, 1998, were HK$61,629,000 (US$7,952,000)and HK$26,842,000
(US$3,464,000) respectively. The Company believes that cash flow generated from
its operations and its existing credit facilities should be sufficient to
satisfy its working capital and capital expenditure requirements for at least
the next 12 months.

        YEAR 2000 DISCLOSURE

        The Company is undergoing a system redevelopment project to improve the
efficiency of the system with respect to changing its computer programs to
properly identify a year in the year field. The cost of such new system is
estimated to be HK$800,000 (US$103,000) and the implementation time is expected
to be by mid-1999 or earlier. The Company has already obtained an
estimate of the cost from the software service company, and in the opinion of
the Management such cost can be controlled as proposed. The Company expects to
incurr the following maintenance charges for the new system:

        1997                 HK$120,000 (US$15,500)
        1998                 HK$ 96,000 (US$12,400)
        1999 and onwards     HK$ 64,000 (US$8,300)

The Company believes that the estimated cost of the new system should not have a
significant impact on the cash flow of the Company.


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<PAGE>

PART II - OTHER INFORMATION

ITEM 1   -   LEGAL PROCEEDINGS

             NONE

ITEM 2   -   CHANGES IN SECURITIES

             NONE

ITEM 3   -   DEFAULTS UPON SENIOR SECURITIES

             NONE

ITEM 4   -   SUBMISSION OF MATTERS TO A VOTE OF SECURITY
             HOLDERS

             NONE

ITEM 5   -   OTHER INFORMATION

             NONE

ITEM 6   -   EXHIBITS AND REPORTS ON FORM 8-K

             The Company did not file reports on FORM 8-K during the quarter
ending September 30, 1998.



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                                SIGNATURES

Pursuant to the requirements of the Exchange Act, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.




                                    PHYSICAL SPA & FITNESS, INC.
                                    (Registrant)

Date: July 1, 1999                  /S/ Ngai Keung Luk
                                    ----------------------------------
                                    Ngai Keung Luk, Chairman and
                                    Chief Executive Officer

Date: July 1, 1999                  /S/ Robert Chui
                                    ----------------------------------
                                    Robert Chui,
                                    Chief Financial Officer