<PAGE>

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                              Washington, DC 20549

                                    FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

                                      or

[ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934


Commission File Number: 0-26573

                           PHYSICAL SPA & FITNESS INC.
                           ---------------------------
             (Exact name of Registrant as specified in its charter)

               Delaware                              98-0203281
   --------------------------------              ------------------
     (State or other jurisdiction                   (IRS Employer
   of incorporation or organization)              Identification No.)

                          40/F Tower One, Times Square
                       No. 1 Matheson Street, Causeway Bay
                                    Hong Kong
                    (Address of principal executive offices)

                                 (852) 2917-0000
                (Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 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 [X] No [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):

  Large accelerated filer [ ] Accelerated filer [ ]  Non-accelerated filer [X]


Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).

                                 Yes [ ] No [X]

As of November 14, 2006, the registrant had 10,000,000 shares of common stock
issued and outstanding.


<PAGE>

                                TABLE OF CONTENTS

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

     Condensed Consolidated Statements of Operations                   1
     for the three-month and nine-month periods
     ended September 30, 2005 and 2006 (Unaudited)

     Condensed Consolidated Balance Sheets at December 31, 2005        2
     and September 30, 2006 (Unaudited)

     Condensed Consolidated Statements of Cash Flows                   3
     for the nine-month periods ended
     September 30, 2005 and 2006 (Unaudited)

     Notes to Financial Statements                                     4

   ITEM 2   -   MANAGEMENT'S DISCUSSION AND ANALYSIS OF                8
                FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   ITEM 3   -   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT        13
                MARKET RISK

   ITEM 4   -   CONTROLS AND PROCEDURES                               13

PART II  -   OTHER INFORMATION

   ITEM 1   -   LEGAL PROCEEDINGS                                     14

   ITEM 2   -   UNREGISTERED SALES OF EQUITY SECURITIES
                  AND USE OF PROCEEDS                                 14

   ITEM 3   -   DEFAULTS UPON SENIOR SECURITIES                       14

   ITEM 4   -   SUBMISSION OF MATTERS TO A VOTE                       14
                OF SECURITY HOLDERS

   ITEM 5   -   OTHER INFORMATION                                     14

   ITEM 6   -   EXHIBITS AND REPORTS ON FORM 8-K                      14



<PAGE>
<TABLE>
<S>     <C>
                                      PHYSICAL SPA & FITNESS INC. AND SUBSIDIARIES
                                      --------------------------------------------

                                UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                     -----------------------------------------------
                                     (In thousands, except share and per share data)


                                                      Three months ended September 30      Nine months ended September 30
                                                       2005        2006        2006        2005        2006         2006
                                                     ---------   ---------   ---------   ---------   ---------   ---------
                                                        HK$         HK$         US$         HK$          HK$         US$

Operating Revenues
Fitness service                                        59,281      60,517       7,758     191,505     173,451      22,237
Beauty treatments                                      48,248      47,070       6,035     147,944     153,899      19,731
Others                                                    383         669          86       1,830       1,487         191
                                                     ---------   ---------   ---------   ---------   ---------   ---------
Total operating revenues                              107,912     108,256      13,879     341,279     328,837      42,159
                                                     ---------   ---------   ---------   ---------   ---------   ---------

Operating Expenses
Salaries and commissions                              (41,282)    (37,423)     (4,798)   (122,182)   (110,711)    (14,194)
Rent and related expenses                             (41,711)    (44,091)     (5,653)   (124,758)   (127,347)    (16,327)
Depreciation                                          (14,832)    (11,411)     (1,463)    (44,694)    (35,025)     (4,490)
Other selling and administrative expenses             (28,844)    (28,929)     (3,709)    (83,442)    (80,613)    (10,335)
                                                     ---------   ---------   ---------   ---------   ---------   ---------
Total operating expenses                             (126,669)   (121,854)    (15,623)   (375,076)   (353,696)    (45,346)
                                                     ---------   ---------   ---------   ---------   ---------   ---------
Loss from operations                                  (18,757)    (13,598)     (1,744)    (33,797)    (24,859)     (3,187)
                                                     ---------   ---------   ---------   ---------   ---------   ---------

Non-operating (expenses) income
Other income, net                                         156         172          22         342       1,226         157
Interest expenses                                        (897)       (455)        (58)     (2,836)     (1,169)       (150)
                                                     ---------   ---------   ---------   ---------   ---------   ---------
Total non-operating (expenses) income                    (741)       (283)        (36)     (2,494)         57           7
                                                     ---------   ---------   ---------   ---------   ---------   ---------

Loss before income taxes and minority interests       (19,498)    (13,881)     (1,780)    (36,291)    (24,802)     (3,180)

Provision for income taxes                                 --          --          --          --          (1)         --
                                                     ---------   ---------   ---------   ---------   ---------   ---------
Loss before minority interests                        (19,498)    (13,881)     (1,780)    (36,291)    (24,803)     (3,180)

Minority interests                                        937         221          28       1,155        (224)        (29)
                                                     ---------   ---------   ---------   ---------   ---------   ---------

Net loss                                              (18,561)    (13,660)     (1,752)    (35,136)    (25,027)     (3,209)
Other comprehensive income:
- Foreign currency translation                            664       1,005         129         664       1,005         129
                                                     ---------   ---------   ---------   ---------   ---------   ---------
Comprehensive loss                                    (17,897)    (12,655)     (1,623)    (34,472)    (24,022)     (3,080)
                                                     =========   =========   =========   =========   =========   =========

Loss per common share                                   (1.86)      (1.37)      (0.18)      (3.51)      (2.50)      (0.32)
                                                     =========   =========   =========   =========   =========   =========
Number of shares of common stock 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 of US$1.00 = HK$7.8. 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 September 30, 2006 or at any
other certain rate.

The financial statements should be read in conjunction with the accompanying notes.


                                                          -1-


<PAGE>

                                     PHYSICAL SPA & FITNESS INC. AND SUBSIDIARIES
                                     --------------------------------------------
                                        CONDENSED CONSOLIDATED BALANCE SHEETS
                                        -------------------------------------
                                   (In thousands, except share and per share data)


                                                                                       As of
                                                               ------------------------------------------------------
                                                       Note       December 31, 2005               September 30, 2006
                                                                                                   (Unaudited)
                                                                          HK$                HK$                US$
ASSETS

Current assets
Cash and bank balances                                                   2,484              1,690                217
Marketable securities, collateralized                                    1,540                 --                 --
Trade receivables                                                       12,925             12,124              1,554
Other receivables                                                        8,173              8,173              1,048
Rental and utility deposits                                             31,486             33,063              4,239
Prepayments and other current assets                                     4,735              5,058                649
Inventories                                                              4,492              2,702                347
Income taxes recoverable                                                 2,129              2,094                268
                                                              -----------------  -----------------  -----------------

Total current assets                                                    67,964             64,904              8,322
                                                              -----------------  -----------------  -----------------

Marketable securities, collateralized                                    2,740              2,740                351
Prepayments for additional investment in a subsidiary    7               6,500             12,000              1,538
Bank deposits, collateralized                                            9,213             10,481              1,344
Due from a stockholder                                                   9,480              9,480              1,215
Property, plant and equipment,
   net of accumulated depreciation of
   HK$365,004 as of September 30, 2006 (2005: HK$331,415)              155,853            130,388             16,716
                                                              -----------------  -----------------  -----------------

Total assets                                                           251,750            229,993             29,486
                                                              =================  =================  =================

LIABILITIES AND STOCKHOLDERS' DEFICIT

Current liabilities
Short-term bank loans                                                    8,415              4,560                585
Long-term bank loans - current portion                   5                  --                320                 41
Trade and other payables                                                50,073             44,110              5,655
Obligations under finance leases - current portion                         286                630                 81
Deferred income - current portion                                      135,008            133,939             17,171
Deferred liabilities - current portion                                   2,795              1,535                196
Income taxes payable                                                       141                248                 32
Taxes other than income                                                  7,581              7,685                985
                                                              -----------------  -----------------  -----------------

Total current liabilities                                              204,299            193,027             24,746
                                                              -----------------  -----------------  -----------------

Deferred income - non-current portion                                   52,878             67,204              8,616
Deferred liabilities -  non-current portion                              5,898              4,779                613
Obligations under finance leases - non-current portion                     119                225                 29
Minority interests                                                       6,156              6,380                818

Commitments and contingencies                            6

Stockholders' deficit:
Common stock, par value US$0.001 each,
   100 million shares of stock authorized;
   10 million shares of stock issued and outstanding                        78                 78                 10
Cumulative translation adjustments                                         825              1,830                235
Accumulated losses                                                     (18,503)           (43,530)            (5,581)
                                                              -----------------  -----------------  -----------------

Total stockholders' deficit                                            (17,600)           (41,622)            (5,336)
                                                              -----------------  -----------------  -----------------

Total liabilities and stockholders' deficit                            251,750            229,993             29,486
                                                              =================  =================  =================

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 of US$1.00 = HK$7.8. 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 September 30, 2006 or at any
other certain rate.

The financial statements should be read in conjunction with the accompanying notes.


                                                         -2-


<PAGE>

                         PHYSICAL SPA & FITNESS INC. AND SUBSIDIARIES
                         --------------------------------------------
                   UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                   ---------------------------------------------------------
                                        (in thousands)


                                                                     Nine Months Ended September 30
                                                                     ------------------------------
                                                                       2005       2006       2006
                                                                     --------   --------   --------
                                                                       HK$        HK$         US$

Cash flows from operating activities:
Net loss                                                            (35,136)   (25,027)     (3,209)

Adjustments to reconcile net loss to net cash provided
  by operating activities:
    Minority interests                                               (1,155)       224          29
    Depreciation                                                     44,694     35,025       4,490
    Loss on disposal of property, plant and equipment                    20        109          14

Changes in working capital:
    Trade receivables                                                (3,130)       843         108
    Rental and utility deposits                                         198     (1,494)       (191)
    Prepayments and other current assets                             (2,832)      (317)        (41)
    Inventories                                                         (59)     1,790         229
    Trade and other payables                                        (10,254)    (6,182)       (792)
    Deferred income                                                  36,104     12,507       1,604
    Deferred liabilities                                             (3,951)    (2,380)       (305)
    Income taxes payable/recoverable                                    573        166          21
    Taxes other than income                                             409        104          13
                                                                    --------    --------   --------

Net cash provided by operating activities                            25,481     15,368       1,970
                                                                    --------    --------   --------

Cash flows from investing activities:
    Prepayments for construction-in-progress                           (422)        --          --
    Prepayments for additional investment in a subsidiary            (6,500)    (5,500)       (705)
    Acquisition of property, plant and equipment                    (13,017)    (7,047)       (903)
    Sales proceeds from disposal of marketable securities                --      1,540         197
    Sales proceeds from disposal of property, plant and equipment        18         12           2
Decrease (Increase) in collateralized bank deposits                   2,346     (1,268)       (163)
                                                                    --------    --------   --------

Net cash used in investing activities                               (17,575)   (12,263)     (1,572)
                                                                    --------    --------   --------

Cash flows from financing activities:
    Settlement of short-term bank loans                              (6,859)    (3,855)       (494)
    Proceeds from long-term bank loans                                   --        510          65
    Repayment of long-term bank loans                                  (638)      (190)        (24)
    Capital element of finance lease rental payments                   (811)      (397)        (51)
                                                                    --------    --------   --------

Net cash used in financing activities                                (8,308)    (3,932)       (504)
                                                                    --------    --------   --------

Net decrease in cash and cash equivalents                              (402)      (827)       (106)

Effect of exchange rate changes                                         (54)        33           4

Cash and cash equivalents at beginning of period                      1,625      2,484         319
                                                                    --------    --------   --------

Cash and cash equivalents at end of period                            1,169      1,690         217
                                                                    ========    ========   ========

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 of US$1.00 = HK$7.8. 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 September 30, 2006 or at any other certain rate.

The financial statements should be read in conjunction with the accompanying notes.


                                                 -3-
</TABLE>


<PAGE>
                  PHYSICAL SPA & FITNESS INC. AND SUBSIDIARIES
                  --------------------------------------------
                          NOTES TO FINANCIAL STATEMENTS
             -----------------------------------------------------
            (Amounts in thousands, except share and per share data)


1. BASIS OF PRESENTATION

         The accompanying unaudited consolidated financial statements include
         the accounts of Physical Spa & Fitness Inc. ("the Company") and the
         subsidiaries that it controls. The Company, through its subsidiaries,
         operates fitness and spa/beauty centers in Hong Kong and China. Unless
         otherwise specified in the text, references to the Company include the
         Company and its subsidiaries. These financial statements should be read
         in conjunction with the consolidated financial statements included in
         the Company's Annual Report on Form 10-K for the year ended December
         31, 2005.

         The accompanying unaudited condensed consolidated financial statements
         have been prepared in accordance with generally accepted accounting
         principles for interim financial information and with the instructions
         to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not
         include all of the information and footnotes required by generally
         accepted accounting principles for complete financial statements. In
         the opinion of management, all adjustments (consisting of normal
         recurring accruals) considered necessary for a fair presentation have
         been included. Operating results for the nine-month period ended
         September 30, 2006 are not necessarily indicative of the results that
         may be expected for the year ending December 31, 2006.

         The balance sheet at December 31, 2005 has been derived from the
         audited financial statements at that date but does not include all of
         the information and footnotes required by generally accepted accounting
         principles for complete financial statements.

2. PREPARATION OF FINANCIAL STATEMENTS

         The Company had negative working capital of HK$136,335 and HK$128,123
         as of December 31, 2005 and September 30, 2006 and incurred losses of
         HK$55,946 and HK$25,027 for the year ended December 31, 2005 and the
         nine months ended September 30, 2006 respectively. In addition, the
         Company had accumulated losses and deficit in stockholders' equity of
         HK$43,530 and HK$41,622 respectively as of September 30, 2006. These
         conditions raised substantial doubt about the Company's ability to
         continue as a going concern.

         Continuation of the Company as a going concern is dependent upon
         attaining profitable operations in the future, exercising tight cost
         and cash flow controls measures, and obtaining additional banking
         facilities and adequate finance as and when required. The financial
         statements do not include any adjustments that might result from the
         outcome of this uncertainty.

         The Principal Stockholder has undertaken to make available adequate
         funds to the Company as and when required to maintain the Company as a
         going concern. Taken into consideration the undertaking provided by the
         Principal Stockholder and continuation of net cash provided by
         operating activities, management believes that the Company will be able
         to settle its liabilities when they come due. As a result, the
         financial statements have been prepared in conformity with the
         principles applicable to a going concern.

3. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

         In March 2006, the EITF reached a consensus on EITF Issue No. 06-3,
         "How Taxes Collected from Customers and Remitted to Governmental
         Authorities Should Be Presented in the Income Statement (That is, Gross
         versus Net Presentation)" that the entities may adopt a policy of
         presenting taxes in the income statement on either a gross or net
         basis. Gross or net presentation may be elected for each different type
         of tax, but similar taxes should be presented consistently. Taxes
         within the scope of this EITF would include taxes that are imposed on a
         revenue transaction between a seller and a customer, for example, sales
         taxes, use taxes, value-added taxes, and some types of excise taxes. If
         taxes are significant an entity should disclose its policy of
         presenting taxes and the amounts of taxes that are recognized on a
         gross basis. The consensus is effective for interim and annual
         financial periods beginning after December 15, 2006. Management
         considers that the adoption of this EITF would not have significant
         impact on its financial statements.



                                       -4-


<PAGE>

                  PHYSICAL SPA & FITNESS INC. AND SUBSIDIARIES
                  --------------------------------------------
                          NOTES TO FINANCIAL STATEMENTS
             -----------------------------------------------------
            (Amounts in thousands, except share and per share data)

3. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED)

         The FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty
         in Income Taxes - an interpretation of FASB Statement 109" ("FIN 48").
         FIN 48 clarifies the accounting for uncertainty in income taxes
         recognized in accordance with FASB Statement No. 109, "Accounting for
         Income Taxes." FIN 48 requires the use of a two-step approach for
         recognizing and measuring tax benefits taken or expected to be taken in
         a tax return and disclosures regarding uncertainties in income tax
         positions. The first step is recognition, whereby a determination is
         made whether it is more-likely-than-not that a tax position will be
         sustained upon examination based on the technical merits of the
         position. The second step is to measure a tax position that meets the
         recognition threshold to determine the amount of benefit to recognize.
         FIN 48 also provides guidance on derecognition, classification,
         interest and penalties, accounting in interim periods, disclosure and
         transition. FIN 48 will be effective for fiscal years beginning after
         December 15, 2006, with earlier adoption permitted. The Company has not
         early adopted FIN 48 and management considers that the adoption of this
         FIN would not have significant impact on its financial statements.

         The FASB has published SFAS No. 157, "Fair Value Measurements", to
         eliminate the diversity in practice that exists due to the different
         definitions of fair value and the limited guidance for applying those
         definitions in generally accepted accounting principles that are
         dispersed among the many accounting pronouncements that require fair
         value measurements. SFAS No. 157 defines fair value as the price that
         would be received to sell an asset or paid to transfer a liability in
         an orderly transaction between market participants at the measurement
         date (an exit price). SFAS No. 157 also stipulates that, as a
         market-based measurement, fair value measurement should be determined
         based on the assumptions that market participants would use in pricing
         the asset or liability, and establishes a fair value hierarchy that
         distinguishes between (a) market participant assumptions developed
         based on market data obtained from sources independent of the reporting
         entity (observable inputs) and (b) the reporting entity's own
         assumptions about market participant assumptions developed based on the
         best information available in the circumstances (unobservable inputs).

         SFAS No. 157 is effective for financial statements issued for fiscal
         years beginning after November 15, 2007, and interim periods within
         those fiscal years, although earlier application is encouraged.
         Additionally, prospective application of the provisions of SFAS No. 157
         is required as of the beginning of the fiscal year in which it is
         initially applied, except when certain circumstances require
         retrospective application. The Company has not early adopted SFAS No.
         157 and management considers that the adoption of this SFAS would not
         have significant impact on its financial statements.

         The FASB has published SFAS No. 158, "Employers' Accounting for Defined
         Benefit Pension and Other Postretirement Plans", to require an employer
         to fully recognize the obligations associated with single-employer
         defined benefit pension, retiree healthcare, and other postretirement
         plans in their financial statements. Previous standards required an
         employer to disclose the complete funded status of its plan only in the
         notes to the financial statements.

         Application of SFAS No. 158 is as follows:
         Initial recognition of a defined benefit postretirement plan and
         related disclosure is required by (a) the end of the fiscal year ending
         after December 15, 2006, for employers with publicly traded securities,
         and (b) at the end of the fiscal year ending after June 15, 2007, for
         all other employers.

         Initial measurement of plan assets and benefit obligations as of the
         date of the employer's fiscal year-end statement of financial position
         is required for fiscal years ending after December 15, 2008.

         Earlier application of the recognition or measurement date provisions
         is encouraged, but must be for all of an employer's benefit plans.
         Retrospective application is not permitted.

         The Company has not early adopted SFAS No. 158 and management considers
         that the adoption of this SFAS would not have significant impact on its
         financial statements.


                                       -5-


<PAGE>

                  PHYSICAL SPA & FITNESS INC. AND SUBSIDIARIES
                  --------------------------------------------
                          NOTES TO FINANCIAL STATEMENTS
             -----------------------------------------------------
            (Amounts in thousands, except share and per share data)


4. REPORT ON SEGMENT INFORMATION

         The Group's operations are mainly classified into two reportable
         business segments: provision of physical fitness and beauty treatment
         services. Each separately managed segment offers different products
         requiring different marketing and distribution strategies.

         Information concerning consolidated operations by business segment is
         presented in the tables below:

<TABLE>

         CONSOLIDATED OPERATIONS BY BUSINESS SEGMENT

                                                    THREE MONTHS ENDED SEPTEMBER 30      NINE MONTHS ENDED SEPTEMBER 30
                                                   ---------------------------------   ---------------------------------
                                                     2005        2006        2006        2005         2006        2006
                                                   ---------   ---------   ---------   ---------   ---------   ---------
                                                      HK$         HK$         US$         HK$         HK$          US$
<S>                                                <C>         <C>         <C>         <C>         <C>         <C>

         Operating revenues
             - Physical fitness                      59,281      60,517       7,758     191,505     173,451      22,237
             - Beauty treatments                     48,248      47,070       6,035     147,944     153,899      19,731
             - Others                                   383         669          86       1,830       1,487         191
                                                   ---------   ---------   ---------   ---------   ---------   ---------

                                                    107,912     108,256      13,879     341,279     328,837      42,159
                                                   =========   =========   =========   =========   =========   =========

         Operating loss
             - Physical fitness                     (16,549)     (8,956)     (1,148)    (33,695)    (24,156)     (3,097)
             - Beauty treatments                     (2,633)     (5,311)       (681)     (1,939)     (2,190)       (281)
             - Others                                   425         669          85       1,837       1,487         191
                                                   ---------   ---------   ---------   ---------   ---------   ---------
                                                    (18,757)    (13,598)     (1,744)    (33,797)    (24,859)     (3,187)

         Other income, net                              156         172          22         342       1,226         157
         Interest expenses                             (897)       (455)        (58)     (2,836)     (1,169)       (150)
         Provision for income taxes                      --          --          --          --          (1)         --
         Minority interests                             937         221          28       1,155        (224)        (29)
                                                   ---------   ---------   ---------   ---------   ---------   ---------
         Net loss                                   (18,561)    (13,660)     (1,752)    (35,136)    (25,027)     (3,209)
                                                   =========   =========   =========   =========   =========   =========
</TABLE>

5. LONG-TERM BANK LOANS

         The Group had obtained additional long-term bank loans of HK$510 during
         the nine-month period ended September 30, 2006.

         During the period under review, the Group repaid HK$190 of its
         outstanding bank loans. The outstanding loan balances as of September
         30, 2006 were analyzed as follows:

PRINCIPAL                     INTEREST RATE         MATURITY
   HK$        US$

   320        41            HK$ prime - 0.5%           2007
 ======     ======

Aggregate maturities of the long-term bank loans are as follows:

PRINCIPAL                    PAYABLE DURING THE FOLLOWING PERIODS
   HK$        US$

    84        11                          2006

   236        30                          2007

--------   --------
   320        41
========   ========


                                       -6-


<PAGE>

6. CONTINGENT LIABILITIES

         The Company imported beauty products from suppliers in Hong Kong into
         the PRC for beauty treatment and sales to its customers. Under the
         prevailing PRC rules and regulations governing imports into the PRC,
         the Company is required to make import declarations and to pay various
         taxes including, inter alia, customs duty, consumption tax and
         value-added tax, on such imports. The Company faced further penalty,
         additional to the original amount of taxes payable, ranging from 50% to
         500% of the original amount of taxes payable, had the Company been
         found in breach of any of such rules and regulations.

         As of December 31, 2005 and September 30, 2006, the Company is
         potentially liable to make good in aggregate an amount of HK$13,833, of
         which an amount of HK$8,173 has been provided for in both balance sheet
         dates as Taxes Other Than Income and as Other Receivables in the
         liabilities and assets respectively. No further provision has been made
         for the difference and any potential amount of penalty which might be
         imposed. In this respect, the directors are of the opinion that the
         probability that such potential liabilities will be crystallized would
         be remote.


7. PREPAYMENTS FOR ADDITIONAL INVESTMENT IN A SUBSIDIARY

         As of December 31, 2005 and September 30, 2006, the Company had
         prepayments of HK$6,500 and HK$12,000 to a minority shareholder of a
         subsidiary for acquisition of its 7.4% equity interest in that
         subsidiary. The consideration is HK$12,000 and the transaction was
         completed in October 2006.


8. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
<TABLE>
<S>                                          <C>
                                            THREE MONTHS ENDED SEPTEMBER 30      NINE MONTHS ENDED SEPTEMBER 30
                                           ---------------------------------   ---------------------------------
                                              2005        2006        2006        2005         2006        2006
                                           ---------   ---------   ---------   ---------   ---------   ---------
                                               HK$         HK$         US$         HK$         HK$          US$
Cash paid (received) for:
    Interest expenses                          897         455         58         2,836        1,169        150
    Income taxes                               (69)       (142)       (18)         (573)        (166)       (21)
Non-cash operating, investing and financing
activities:
    Acquisition of property, plant and
    equipment under capital leases             572          --         --           572          846        108

</TABLE>


9. COMPARATIVE INFORMATION

         Certain reclassifications have been made to the consolidated balance
         sheet as of December 31, 2005 and the consolidated statement of cash
         flows for the period ended September 30, 2005 to conform to the current
         period's presentation.

10. SUBSEQUENT EVENTS

         On October 31, 2006, the Company entered into two material definitive
         agreements, as follows: (a) a Share Exchange Agreement, dated October
         31, 2006 (the "Share Exchange Agreement"), between the Company and Mr.
         Ngai Keung Luk, a majority shareholder and Chairman of the Company
         ("Mr. Luk"), pursuant to which Mr. Luk has agreed to transfer 100% of
         the shares which he owns of Ableforce International Limited, a British
         Virgin Islands corporation ("Ableforce"), to the Company in exchange
         for the issuance by the Company to Mr. Luk of a total of 15,328,070
         shares of the Company's common stock, $.001 par value. Ableforce is
         primarily engaged in property investment in Hong Kong; and (b) a
         Disposal Agreement, dated October 31, 2006 (the "Disposal Agreement"),
         between the Company and Mr. Luk, pursuant to which the Company has
         agreed to transfer to Mr. Luk the sole outstanding common share of
         Physical Beauty & Fitness Holdings Limited, a British Virgin Islands
         corporation and wholly owned subsidiary of the Company ("Physical
         Beauty"), which is the holding company for subsidiaries that operate
         seventeen fitness and spa facilities located in Hong Kong and the
         People's Republic of China, including one facility in Macau. After the
         consummation of the transactions contemplated by the Disposal Agreement
         including the sale of the stock of Physical Beauty, the Company will no
         longer be engaged in the fitness and spa center business, and will own
         and operate residential apartments. It will change its name to Physical
         Property Holdings Inc.

                                       -7-



<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. 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. The Company currently operates seventeen facilities:
thirteen in Hong Kong and four in China (including one in Macau). In addition,
the Company is appointed by outside investors to manage two fitness and spa
centers in Dalian and Shao Xing, China respectively. The Company also grants
the use of the trade name to a third party for operating a fitness and spa
center in Hangzhou, 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 110,000 customers. 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 (Mr. Luk), a 100%
shareholder of Physical Limited, whereby the Company entered into a Share
Exchange Agreement with Mr. Luk, pursuant to which the Company issued 8,000,000
pre-split (6,000,000 post-split) shares of its Common Stock to Mr. Luk 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.


                                      -8-


<PAGE>

RESULTS OF OPERATIONS

         The Company's revenues are derived from its two main lines of business
of fitness and spa services in the following principal ways: admission fees and
monthly subscription fees from the fitness customers, and the sale of beauty
treatments and skin care products to the beauty patrons.

         In respect to fitness services, each customer will be charged a monthly
due of HK$328 (US$42) for the usage of the fitness centers. During promotional
period, discounts on the monthly dues will be offered to customers.

         In respect to beauty services, the customers may purchase single
treatment, 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$400 (US$51) to HK$15,000 (US$1,923).

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

<TABLE>

RESULTS OF OPERATIONS

                                                 Three Months Ended          Nine Months Ended
                                                     September 30               September 30
                                                 2005          2006           2005         2006
                                              -----------  -----------    -----------  -----------
<S>                                             <C>         <C>               <C>         <C>
Operating Revenues                              100.00%     100.00%           100.00%     100.00%

Total operating expenses                        117.38%     112.56%           109.90%     107.56%

Operating loss                                  (17.38%)    (12.56%)           (9.90%)     (7.56%)

Loss before income taxes and
minority interests                              (18.07%)    (12.82%)          (10.63%)     (7.54%)

Provision for income taxes                          --          --                --          --

Minority interests                                0.87%       0.20%             0.33%      (0.07%)

Net loss                                        (17.20%)    (12.62%)          (10.30%)     (7.61%)
                                             ===========  ===========       ===========  ==========
</TABLE>


THREE MONTHS ENDED SEPTEMBER 30, 2006 (UNAUDITED) COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 2005 (UNAUDITED).
--------------------------------------------------------------------------------

         OPERATING REVENUES. Operating revenues for the third quarter of
2006 totaled HK$108,256,000 (US$13,879,000) compared to HK$107,912,000
(US$13,835,000) of last year. This represented a slight increase of 0.3%.

         Fitness services which constituted 56% of total operating revenues,
increased by 2% to HK$60,517,000 (US$7,758,000) in the third quarter of the
year.

         Beauty services, being 43% of total operating revenues, decreased
by 2% to HK$47,070,000 (US$6,035,000). This quarter has seen a weakening
demand in the beauty industry.


                                      -9-



<PAGE>

         Operating revenues from others were HK$669,000 (US$86,000) in the
third quarter which was mainly contributed by the management service fees from
the franchisees.

         OPERATING EXPENSES. The Company's operating expenses totaled
HK$121,854,000 (US$15,623,000), or 113% of operating revenues, for the third
quarter of 2006, compared to HK$126,669,000 (US$16,240,000), or 117% of
operating revenues, for the third quarter of 2005. This represented a decrease
of HK$4,815,000 (US$617,000) mainly due to an effective cost control over the
operating expenses, especially salaries which decreased by HK$3,859,000
(US$495,000). However, certain fixed costs remained high. In particular, rent
and related expenses had increased from 39% to 41% of total operating revenues.
Having regard to the continuous increase in the market rent, the Company will
constantly evaluate the performance of each center to determine whether or not a
renewal of tenancy upon expiration is justifiable.

         TOTAL NON-OPERATING EXPENSES. Total non-operating expenses for the
third quarter of 2006 totaled HK$283,000 (US$36,000) compared to HK$741,000
(US$95,000) of 2005. This represented a decrease of 62% mainly due to lower
interest expenses.

         PROVISION FOR INCOME TAXES. The Company did not make any tax provision
for the third quarter in view of the losses incurred.

         NET LOSS. The Company has suffered a net loss of HK$13,660,000
(US$1,752,000) for the third quarter of 2006, compared to a net loss of
HK$18,561,000 (US$2,380,000) for 2005, representing a decrease of 26%. The
management believes that the keen competition in the industry will continue
to hinder the business growth.  The Company will monitor the market development
and seek other opportunities to maximize the benefit to its stockholders.


NINE MONTHS ENDED SEPTEMBER 30, 2006 (UNAUDITED) COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2005 (UNAUDITED).
----------------------------------------------------------------------------

         OPERATING REVENUES. Operating revenues for the first nine months of
2006 totaled HK$328,837,000 (US$42,159,000) compared to HK$341,279,000
(US$43,754,000) of last year. This represented a decrease of 4%, mainly due to
keen competition especially in the fitness market.

         Fitness services which constituted 53% of total operating revenues,
decreased by 9% to HK$173,451,000 (US$22,237,000) in the first nine months of
the year.

         Beauty services, being 47% of total operating revenues, increased
by 4% to HK$153,899,000 (US$19,731,000).

         OPERATING EXPENSES. The Company's operating expenses for the first nine
months of the year totaled HK$353,696,000 (US$45,346,000) compared to last
year's HK$375,076,000 (US$48,087,000), representing a decrease of HK$21,380,000
(US$2,741,000) or 6%. This included a cost reduction in salaries by
HK$11,471,000 (US$1,471,000) and marketing expenses of HK$3,469,000
(US$445,000). The Company intends to continue the exercise of stringent control
over staff headcount, usage of public utilities, and efficiency in marketing and
promotional activities.

         TOTAL NON-OPERATING INCOME (EXPENSES). Total non-operating income for
the first nine months of 2006 totaled HK$57,000 (US$7,000) compared to a
non-operating expense of HK$2,494,000 (US$320,000) in 2005. This represented an
increase of 102% reflecting a surplus of other income over the interest
expenses.

         PROVISION FOR INCOME TAXES. Except for an adjustment of federal tax, no
income taxes were provided for the first nine months of 2006 because of losses
incurred.

         NET LOSS. The loss had narrowed to HK$25,027,000 (US$3,209,000) in the
nine month ended September 30, 2006, compared to a net loss of HK$35,136,000
(US$4,505,000) of the same period last year. The keen competition has impacted
adversely the business of the Company; however, the management is determined to
provide value-for-money service to its customers for maintaining its market
share in the last quarter of the year.


                                      -10-


<PAGE>

LIQUIDITY AND CAPITAL RESOURCES

         The Company has financed its operations primarily through cash
generated from operations, short-term bank credit, long-term bank loans,
advances from customers relating to prepaid fitness and spa income, and leasing
arrangements with financial institutions.

         Cash and cash equivalent balances as of September 30, 2006 and December
31, 2005 were HK$1,690,000 (US$217,000) and HK$2,484,000 (US$318,000).

         Net cash provided by operating activities were HK$25,481,000
(US$3,267,000) and HK$15,368,000 (US$1,970,000) for the nine-month periods ended
September 30, 2005 and 2006, respectively. The Company's operating activities
are historically financed by cash flows from operations.

         Net cash used in investing activities were HK$17,575,000 (US$2,253,000)
and HK$12,263,000 (US$1,572,000) for the nine-month periods ended September 30,
2005 and 2006 respectively, primarily as a result of expenditures for property,
plant and equipment. Total capital expenditures were as follows:

<TABLE>
                                                               (in thousands)
                                                      Nine months ended September 30
                                                       2005        2006        2006
                                                     ---------   ---------   ---------
                                                        HK$         HK$         US$
<S>                                                  <C>         <C>         <C>

Cash purchases of property, plant and equipment       13,017      7,047         903
Non-cash property, plant and equipment purchases
financed through capital lease obligations               572        846         108
                                                      ------     ------       -----

Total capital expenditures                            13,589      7,893       1,011
                                                      ======     ======       =====

         The following schedule reflects capital expenditures by type of
expenditure:

                                                                (in thousands)
                                                       Nine months ended September 30
                                                       2005        2006        2006
                                                     ---------   ---------   ---------
                                                        HK$         HK$         US$

Capital expenditures for new center                     6,750        --          --
Captial expenditures for maintenance and updating
existing centers and corporate office                   6,839      7,893       1,011
                                                       ------     ------       -----

Total capital expenditures                             13,589      7,893       1,011
                                                       ======     ======       =====


</TABLE>

         Net cash used in financing activities, which mainly include proceeds
from bank loans, net interest and repayment, were HK$8,308,000 (US$1,065,000)
and HK$3,932,000 (US$504,000) in the nine-month periods ended September 30, 2005
and 2006, respectively.


                                      -11-


<PAGE>

         During the nine-month period ended September 30, 2006, the Company has
not entered into any transactions using derivative financial instruments or
derivative commodity instruments nor held any marketable equity securities of
publicly traded companies. Accordingly, the Company believes its exposure to
market interest rate risk and price risk is not material. The Company's
long-term loan bears interest rate of 7.75% per annum. The total balance
outstanding as of September 30, 2006 on such loan was HK$320,000 (US$41,000).
The last repayment on the loan is due in 2007.

         During the nine-month period ended September 30, 2006, the Company had
no material purchases of investments.

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

         The Company's trade receivable balance at September 30, 2006, was
HK$12,124,000 (US$1,554,000). These trade receivables are mainly amounts due
from major credible banks which do not have the history of credit risk.

         As disclosed in Note 2 to the financial statements, the Company had
negative working capital of HK$128,123,000 (US$16,424,000) as of September 30,
2006 and incurred losses of HK$25,027,000 (US$3,209,000) for the period ended
September 30, 2006. In addition, the Company had accumulated losses and deficit
in stockholders' equity of HK$43,530,000 (US$5,581,000) and HK$41,622,000
(US$5,336,000) respectively as of September 30, 2006. These conditions raised
substantial doubt about the Company's ability to continue as a going concern. In
order to maintain it as a going concern, the management is seeking to procure
additional funding from various sources. In addition, the Principal Stockholder
has also undertaken to make available adequate funds to the Company as and when
required to maintain the Company as a going concern. Moreover, the negative
working capital was mainly because of non-cash items including deferred income
and deferred liabilities while the loss for the period was mainly attributable
to the depreciation expense. Having excluded these non-cash items and taken into
consideration the undertaking provided by the Principal Stockholder, the
management believes that cash flow generated from the operations of the Company,
the tight cost and cash flow control measures and the existing and additional
credit facilities to be sought should be sufficient to satisfy the working
capital and capital expenditure requirements of the Company for at least the
next 12 months.


                                      -12-



<PAGE>

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in conformity with accounting principles
generally accepted in the U.S., or GAAP, requires the Company to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. In recording
transactions and balances resulting from business operations, the Company uses
estimates based on the best information available. The Company uses estimates
for such items as depreciable lives and the amortization period for deferred
income. The Company revises the recorded estimates when better information is
available, facts change or actual amounts can be determined. These revisions can
affect operating results.

The critical accounting policies and use of estimates are discussed in and
should be read in conjunction with the annual consolidated financial statements
and notes included in the latest 10-K, as filed with the SEC, which includes
audited consolidated financial statements for the three fiscal years ended
December 31, 2005.

ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The operations of the Company are located in Hong Kong and the PRC and most of
the operating revenues are earned in these two areas. Therefore the Company is
not exposed to risks relating to fluctuating currencies or exchange rates.
Besides, the Company has not purchased options or entered into swaps or forward
or futures contracts. The primary market risk exposure is that of interest rate
risk on borrowings that the Company may have under some future credit facility.

ITEM 4 - CONTROLS AND PROCEDURES

The Chief Executive Officer and Chief Financial Officer (the principal executive
officer and principal financial officer, respectively) of the Company have
concluded, based on their evaluation as of September 30, 2006, that the design
and operation of the Company's "disclosure controls and procedures" (as defined
in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended
("Exchange Act")) are, to the best of their knowledge, effective to ensure that
information required to be disclosed in the reports filed or submitted by the
Company under the Exchange Act is accumulated, recorded, processed, summarized
and reported to the management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding whether or
not disclosure is required.

During the interim period ended September 30, 2006, there were no changes in the
internal controls of the Company over financial reporting (as defined in Rule
13a-15(f) under the Exchange Act) that have materially affected, or are
reasonably likely to materially affect, the internal controls of the Company
over financial reporting.


                                      -13-




<PAGE>

PART II - OTHER INFORMATION

ITEM 1  - LEGAL PROCEEDINGS

          NONE

ITEM 2  - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

          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

         31       Certification of the Chief Executive Officer and Chief
                  Financial Officer Pursuant to Rule 13a-14(a) or Rule 15d-14(a)
                  of the Securities Exchange Act of 1934

         32.1     Certification of the Company's Chief Executive Officer
                  Pursuant to 18 U.S.C. SS. 1350 Adopted Pursuant to Section 906
                  of the Sarbanes-Oxley Act of 2002

         32.2     Certification of the Chief Financial Officer Pursuant to 18
                  U.S.C. SS. 1350 Adopted Pursuant to Section 906 of the
                  Sarbanes-Oxley Act of 2002

         The Company filed a report on FORM 8-K on November 6, 2006 with respect
         to Item 1.01.


                                      -14-



<PAGE>

                                   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: November 13, 2006                  /s/ Ngai Keung Luk
                                    ------------------------------------
                                    Ngai Keung Luk,
                                    Chairman and Chief Executive Officer

Date: November 13, 2006                  /s/ Darrie Lam
                                    ------------------------------------
                                    Darrie Lam,
                                    Chief Financial Officer


                                      -15-